Growth Rate Analysis

Growth rates refer to the percentage change of a specific

variable within a specific time period.

For investors, growth rates typically represent the compounded

annualized rate of growth of a company's revenues, earnings,
dividends, or even macro concepts, such as gross domestic
product (GDP) and retail sales.

Why Growth Rates?

Growth rates are utilized by analysts, investors, and a
company's management to assess a firm's growth periodically
and make predictions about future performance.

So Growth Rate Analysis is done with two objectives:-

to assess a firm's growth periodically
make predictions about future performance.
Growth Rate Analysis
How to assess a firm's growth periodically?
Periodical growth rate is calculated by taking the difference between the current
and former level and dividing that amount by the former level. A simple example
illustrates the concept:

Particulars 2017 2018 Growth

Revenue $177.9 billion $232.89 billion (232.89-177.9)/177.9*100 = 30.93%
Earnings $3.03 billion $10.07 billion (10.07-3.03)/3.03*100 = 232%

A common modification to this approach is the compound annual growth rate

(CAGR), which describes the rate at which an investment would have grown if it
had grown the same rate every year and the profits were reinvested at the end of
each year. The formula for calculating CAGR is:

CAGR=(EV/​BV)^(1/n) ​−1
where:
EV=Ending value
BV=Beginning value
n=Number of years​
Growth Rate Analysis

How to make predictions about future performance?

The most common growth rate metrics investors and analysts consider in
evaluating a company's future prospects and suitability as an investment are
revenues and earnings, the price-to-earnings (P/E) ratio, the price-to-
earnings-to-growth (PEG) ratio, and return on equity (ROE).

How Expected Growth in Revenue and earnings

plays a role in making predictions about future
performance?

Imagine two identical companies which both earn $10 million this year.
Company Earnings Earning after 10 years
Growth
A 15 $40.5 million
B 5 $16.3 million
Growth Rate Analysis
How to estimate the growth rate in earnings?
The easiest way to come up with a growth rate is to see what analysts are saying.

For example, on Yahoo Finance you can find out that, on average, analysts expect that Apple (AAPL)
will grow its earnings at a rate of 12.24% per year for the coming 5 years.

Seems like a great plan to listen to what these analysts are saying, because they are the experts,
rights?

Research by McKinsey & Co.concluded that Wall Street analysts are as good as always too
optimistic.

But what is too optimistic?

Well, the authors state that “on average, analysts’ forecasts have been almost 100 percent too
high.” 100%!! So if analysts say they expect a company to grow its earnings at 10% a year, the actual
growth will most likely be closer to 5% a year.
Growth Rate Analysis

HISTORICAL EPS GROWTH
Another way to get an idea of the future growth potential of a company is by looking
at how fast the company has been able to grow its earnings over the last ten years.

Let's take Google (GOOGL) as an example.

2004 2014
EPS - $0.73 EPS - $19.37

This is equal to an impressive 38.8% annual compounded growth rate ($19.37 / $0.73 ^ 1/10).

So over the last 10 years Google has, on average, grown its EPS with 38.8% a year.
Now ask yourself, is it realistic to expect that Google will keep growing at that rate for the
coming 10 years?
Keep in mind that this means Google will have to earn 26 times more in ten years time than
the $13.2 billion they are earning today! This seems highly unlikely.
Growth Rate Analysis

SUSTAINABLE GROWTH RATE

There exists something called the Sustainable Growth Rate.
The name suggests that this is exactly what we need, so let's
take a closer look.

The Sustainable Growth Rate is the maximum rate at which a

company can grow without taking on additional debt. This is
good, because we want to invest in companies which are able
to fund their growth with their own earnings. The Sustainable
Growth Rate is calculated as follows:

ROE x (1 - dividend payout ratio)

It takes the ROE ratio and adjusts it for any dividends that are
paid out, because only Retained Earnings (Net Income -
Dividends) can be used to grow the business.
 Growth Rate Analysis
A REALISTIC GROWTH RATE
However, what we are looking for is a realistic rate at which we can expect a company to grow over the coming
years, not a maximum rate. This makes the Sustainable Growth Rate far from perfect.
If, for example, a company decides to take on $10 million in Long-Term Debt to generate more earnings, the amount
of Shareholders' Equity would remain the same, but the ROE figure would nevertheless rise because of the higher
earnings.
So ROE is flawed because it does not take debt into account and because ROE is a key input for the Sustainable
Growth Rate, it too is flawed.

So how do we fix this?

Well, we could add Long-Term Debt to Shareholders' Equity before calculating the return, which essentially means
we are no longer using the Return on Equity but the Return on Capital. This way we take debt into account. Also, we
could use Depreciation & Amortization expenses as a proxy of maintenance and replacement costs of machines, and
therefore subtract this from retained earnings to get a more accurate view of the amount of money that can be used
to grow the business.

So is this then the perfect formula for growth?

Not quite. We are still basing this formula on a lot of assumptions. That is why I suggest you compare this rate
to the analyst expectations and historical EPS growth rate to make sure you are not being overly optimistic.
Also, look at how consistent the earnings of the company have been over the past ten years.
Scenario and Sensitivity Analysis
Scenario analysis
Scenario analysis is the process of
estimating the expected value of a portfolio
after a given change in the values of key
factors take place.
Both likely scenarios and unlikely worst-
case events can be tested in this fashion—
often relying on computer simulations.
Stress Testing
Stress testing is often employed using a
computer simulation technique to test the
resilience of institutions and investment
portfolios against possible future critical
situations.
Such testing is customarily used by the
financial industry to help gauge investment
risk and the adequacy of assets.
Scenario and Sensitivity Analysis
What Is Sensitivity Analysis?
A sensitivity analysis determines how different values
of an independent variable affect a particular
dependent variable under a given set of assumptions. 

Assume Ms. P is a sales manager who wants to

understand the impact of customer traffic on total
sales.
Price Sales (Qty.) Sales (Rs.)
$1,000 100 $100,000

Sue also determines that a 10% increase in customer

traffic increases transaction volume by 5%.
Now, change in transaction with respect to a change in
traffic is shown as:
Customer Traffic Increase Sales Increase
10% 5%
50% 25%
100% 50%
Scenario and Sensitivity Analysis
Sensitivity vs. Scenario Analysis
Assume an equity analyst wants to do a sensitivity analysis and a scenario analysis around the
impact of earnings per share (EPS) on a company's relative valuation by using the price-to-
earnings (P/E) multiple.

The sensitivity analysis is based on the variables that affect valuation, which a financial model can
depict using the variables' price and EPS. The sensitivity analysis isolates these variables and then
records the range of possible outcomes.

On the other hand, for a scenario analysis, the analyst determines a certain scenario such as
a stock market crash or change in industry regulation.

He then changes the variables within the model to align with that scenario. Put together, the
analyst has a comprehensive picture. He now knows the full range of outcomes, given all
extremes, and has an understanding of what the outcomes would be, given a specific set of
variables defined by real-life scenarios.
Variance Analysis
Variance analysis is an analysis of the difference between planned and actual numbers. The sum of all variances
gives a picture of the overall over-performance or under-performance for a particular reporting period.
Variance Analysis
Types of Variances
Materials, labor, and variable overhead consist of price
and quantity/efficiency variances.
Fixed overhead, however, includes a volume variance
and a budget variance.
When calculating for variances, the simplest way is to
follow the column method and input all the relevant
information.
This method is best shown through the
example below:
XYZ Company produces gadgets. Overhead is applied to products based on direct labor hours.
The denominator level of activity is 4,030 hours. The company’s standard cost card is below:

Cost Driver Cost Detail

Direct materials 6 pieces per gadget at $0.50 per piece

Direct labor 1.3 hours per gadget at $8 per hour

Variable manufacturing overhead 1.3 hours per gadget at $4 per hour
Fixed manufacturing overhead 1.3 hours per gadget at $6 per hour
Variance Analysis

During January, the company produced 3,000 gadgets. The fixed overhead expense budget
was $24,180. Actual costs in January were as follows:
  
Cost Driver Cost Detail
 Direct materials 25,000 pieces purchased at the cost of
$0.48 per piece
Direct labor 4,000 hours were worked at the cost of
$36,000
Variable manufacturing overhead Actual cost was $17,000
Fixed manufacturing overhead Actual cost was $25,000
Variance Analysis
Material Variance

Adding these two variables together, we get an overall variance of $3,000 (unfavorable). It is a
variance that management should look at and seek to improve.
Although price variance is favorable, management may want to consider why the company
needs more materials than the standard of 18,000 pieces. It may be due to the company
acquiring defective materials or having problems/malfunctions with machinery
Variance Analysis
Labor Variance

Adding the two variables together, we get an overall variance of $4,800 (Unfavorable).
This is another variance that management should look at. Management should address why the actual
labor price is a dollar higher than the standard and why 1,000 more hours are required for production.
The same column method can also be applied to variable overhead costs. It is similar to the labor
format because the variable overhead is applied based on labor hours in this example.
Variance Analysis
Fixed Overhead Variance

Adding the budget variance and volume variance, we get a total unfavorable variance of $1,600. Once
again, this is something that management may want to look at.
Variance Analysis
Root Cause Analysis
Root cause analysis (RCA) is the process of discovering the root causes of problems in order to identify appropriate
solutions. RCA assumes that it is much more effective to systematically prevent and solve for underlying issues rather
than just treating ad hoc symptoms and putting out fires.

Goals and benefits


The first goal of root cause analysis is to discover the root cause of a problem or event.

The second goal is to fully understand how to fix, compensate, or learn from any underlying issues within the root
cause.

The third goal is to apply what we learn from this analysis to systematically prevent future issues or to repeat
successes.

Core principles

Focus on correcting and remedying root causes rather than just symptoms.

Don’t ignore the importance of treating symptoms for short term relief.

Realize there can be, and often are, multiple root causes.

Focus on HOW and WHY something happened, not WHO was responsible.

Be methodical and find concrete cause-effect evidence to back up root cause claims.

Provide enough information to inform a corrective course of action.

Consider how a root cause can be prevented (or replicated) in the future.
 Variance Analysis
Another useful method of exploring root cause analysis is to carefully Analyze the changes leading up to an event.
Let’s say the event we’re going to analyze is an uncharacteristically successful day of sales in New York City, and we
wanted to know why it was so great so we can try to replicate it.

2. we’d categorize each 3. we’d go event by event and 4. we look to see

change or event by how decide whether or not that event how we can
much influence we had was an unrelated factor, a replicate or remedy
1. we’d list out correlated factor, a contributing the root cause.
over it.
every touch factor, or a likely root cause.
point with each
of the major
customers, we’d start to sort out  We discover new Sales slide While not everyone
every event, things like deck was actually an unrelated can move to a new
every possibly  Sales representative factor apartment, our
relevant presented new slide  But the end of the quarter was organization decides
change. deck on social impact” definitely a contributing factor. that if Sales reps
(Internal) and other  However, the most likely root show up an extra 10
events like cause: the Sales Lead for the minutes earlier to
 “Last day of the area moved to a new client meetings in the
quarter” (External) or apartment with a shorter final week of a
 “First day of Spring” commute, meaning that she quarter, they may be
(External). started meetings with clients able to replicate this
10 minutes earlier during last root cause success .

week of quarter.
Variance Analysis
Cause and effect Fishbone diagram
Another common technique is creating a Fishbone diagram, to visually map cause and effect.
Process
Typically we start with Then brainstorm several As we dig deeper into
the problem in the categories of causes, which are After grouping the categories, potential causes and sub-
middle of the diagram then placed in off-shooting we break those down into the causes, questioning each
(the spine of the fish branches from the main line (the smaller parts. branch, we get closer to
skeleton), rib bones of the fish skeleton). the sources of the issue.
Variance Analysis
Common categories to consider in a Fishbone diagram:
Liquidity Ratio Analysis

Definition
Liquidity ratios are financial ratios that measure a company’s
ability to repay both short- and long-term obligations.
Use of Liquidity ratios
Liquidity ratios are commonly used by prospective creditors and
lenders to decide whether to extend credit or debt, respectively, to
companies.
Common liquidity ratios include the following:
 Current ratio
 Acid-test ratio
 Absolute Liquid Ratio
 Cash ratio
 Operating cash flow ratio
Liquidity Ratios

Acid test Ratio

The acid-test ratio measures a company’s ability to pay off short-
term liabilities with quick assets. Ideal = 1:1

Absolute Liquid Ratio 

Absolute Liquid Ratio is a type of liquidity ratio that is calculated to analyze the short
term solvency or financial position of the firm. Ideal 1:2
Liquidity Ratios

Liquidity Ratios
Cash ratio 
The cash ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents:

Operating cash flow ratio 

The operating cash flow ratio is a measure of the number of times a company can pay off current liabilities with
the cash generated in a given period:

23
Leverage Financial Ratios

Leverage Financial Ratios

Definition
Leverage ratios measure the amount of capital that comes from debt. In other words, leverage
financial ratios are used to evaluate a company’s debt levels.
Uses of Leverage ratios
Leverage ratios are used to measure solvency of a company, its financial structure and how it
operates with the given fund (equity and debt). It is used by creditors, investors as well as the internal
management to evaluate the company's growth, ability to clear all dues/debts/interests.
Common leverage ratios include the following:
 Debt ratio
 Debt to equity ratio
 Interest coverage ratio
 Debt service coverage ratio
 Leverage Financial Ratios

Debt ratio 
The debt ratio measures the relative amount of a company’s assets that are
provided from debt

Ideal Debt Ratio

In general, many investors look for a company to have a debt ratio
between 0.3 and 0.6.From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a
debt ratio of 0.6 or higher makes it more difficult to borrow money. 

Debt to equity ratio 

The debt to equity ratio calculates the weight
of total debt and financial liabilities against shareholders’ equity.

Ideal Debt to equity Ratio

Generally, a good debt-to-equity ratio is anything lower than 1.0. A ratio of 2.0 or higher is usually
considered risky. If a debt-to-equity ratio is negative, it means that the company has more liabilities than
assets—this company would be considered extremely risky.
 
 Leverage Financial Ratios

Debt to equity ratio 

In the above Formulae,
Debt = Short term Debt + Long term Debt + Other Fixed payments
Equity = Equity Share Capital + Reserves and surplus

26
Leverage Financial Ratios
Problems with the Above formula:
Particulars Company A Company B
Short term Payables $1 million $500,000
long-term debt $500,000 $1 million
shareholder equity $1.5 million $1.5 million
D/E ratio 1.00 1.00

On the surface, the risk from leverage is identical, but in reality, the second company is riskier. Because short-term
debt tends to be cheaper than long-term debt, and it is less sensitive to shifting interest rates, meaning the second
company’s interest expense and cost of capital are higher.
Solution:
A common approach to resolving this issue is to modify the D/E ratio into the long-term D/E ratio. An approach like
this helps an analyst focus on important risks.
Long-term Debt Equity Ratio = Long term Debt / Shareholders Equity
Summary:
 Debt to equity ratio  is a measure of the degree to which a company is financing its operations through debt versus
wholly owned funds.
27
 It reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn. . 
Efficiency Ratios

Efficiency Ratios
Definition
Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is
utilizing its assets and resources.
Uses of Efficiency ratios
Efficiency ratios compare what a company owns to its sales or profit performance and inform investors
about a company's ability to use what it has to generate the most profit possible for owners and
shareholders.
Common efficiency ratios include:
 Asset turnover ratio 
 Inventory turnover ratio
 Receivables turnover ratio 
 Days sales in inventory ratio 
 Efficiency Ratios

Asset turnover ratio 

The asset turnover ratio measures a company’s ability to generate sales from asset s

Ideal Asset turnover ratio

In the retail sector, an asset

turnover ratio of 2.5 or more
could be considered good, while a
company in the utilities sector is more likely
to aim for an asset turnover ratio that's between 0.25 and 0.5.
 

Inventory turnover ratio 

The inventory turnover ratio measures how many times
a company’s inventory is sold and replaced over a given period

Ideal Inventory turnover ratio

A good inventory turnover ratio is between
5 and 10 for most industries, which indicates that you
sell and restock your inventory every 1-2 months. This ratio
strikes a good balance between having enough
inventory on hand and not having to reorder too frequently.
Efficiency Ratios

Accounts receivable turnover ratio

The accounts receivable turnover ratio measures how many times a company can
turn receivables into cash over a given period.
 

Days sales in inventory ratio 

The days sales in inventory ratio measures the
average number of days that a company holds
on to inventory before selling it to customers.
Efficiency Ratios

Working capital turnover Ratio

Working Capital Turnover = Net Annual Sales / Average Working Capital
where:
Net annual sales is the sum of a company's gross sales minus its returns, allowances, and discounts over the
course of a year.
Average working capital is average current assets less average current liabilities.

31
Efficiency Ratios

Working capital turnover Ratio

Interpretation
 A high working capital turnover ratio shows a company is running smoothly
and has limited need for additional funding. Money is coming in and flowing
out regularly, giving the business flexibility to spend capital on expansion or
inventory. A high ratio may also give the business a competitive edge over
similar companies as a measure of profitability.
 However, an extremely high ratio might indicate that a business does not have
enough capital to support its sales growth. Therefore, the company could
become insolvent in the near future unless it raises additional capital to support
that growth.
Limitation

Working Capital Turnover = Net

 The working capital turnover indicator may also be misleading when a firm's Annual Sales / Average Working
accounts payable are very high, which could indicate that the company is Capital
having difficulty paying its bills as they come due.
32
Efficiency Ratios

Cash Conversion Cycle

The cash conversion cycle (CCC) is a metric that expresses the time
(measured in days) it takes for a company to convert its investments in
inventory and other resources into cash flows from sales.
CCC=DIO+DSO−DPO
where:
DIO=Days of inventory outstanding
(also known as days sales of inventory)
DSO=Days sales outstanding OR
Collection Days
DPO=Days payables outstanding OR
Payment days
​

33
 Efficiency Ratios

Cash Conversion Cycle

 The first stage focuses on the existing inventory level and represents how long it will take for the business to sell its
inventory. This figure is calculated by using the Days Inventory Outstanding (DIO). A lower value of DIO is
preferred, as it indicates that the company is making sales rapidly, and implying better turnover for the business.
 The second stage focuses on the current sales and represents how long it takes to collect the cash generated from the
sales. This figure is calculated by using the Days Sales Outstanding (DSO), which divides average accounts
receivable by revenue per day. A lower value is preferred for DSO, which indicates that the company is able to
collect capital in a short time, in turn enhancing its cash position.
 The third stage focuses on the current outstanding payable for the business. It takes into account the amount of
money the company owes its current suppliers for the inventory and goods it purchased, and it represents the time
span in which the company must pay off those obligations. This figure is calculated by using the Days Payables
Outstanding (DPO), which considers accounts payable. A higher DPO value is preferred. By maximizing this
number, the company holds onto cash longer, increasing its investment potential .

34
Efficiency Ratios

Cash Conversion Cycle

Interpretation:
 CCC traces the lifecycle of cash used for business activity. It follows the
cash as it's first converted into inventory and accounts payable, then into expenses
for product or service development, through to sales and accounts receivable, and
then back into cash in hand.
 Inventory management, sales realization, and payables are the three key ingredients of business. If any of
these goes for a toss—say, inventory mismanagement, sales constraints, or payables increasing in number,
value, or frequency—the business is set to suffer.
 CCC may not provide meaningful inferences as a stand-alone number for a given period. Analysts use it to
track a business over multiple time periods and to compare the company to its competitors .
 Tracking a company’s CCC over multiple quarters will show if it is improving, maintaining, or
worsening its operational efficiency.
 While comparing competing businesses, investors may look at a combination of factors to select the
best fit.
 If two companies have similar values for return on equity (ROE) and return on assets (ROA), it may
be worth investing in the company that has a lower CCC value. It indicates that the company is able
to generate similar returns more quickly . 35
 Efficiency Ratios

Cash Conversion Cycle

CCC has a selective application to different industrial sectors based on the nature of
business operations.
 The measure has a great significance for retailers like Walmart Inc. (WMT),
Target Corp. (TGT), and Costco Wholesale Corp. (COST), which are involved in buying and managing
inventories and selling them to customers. All such businesses may have a high positive value of CCC .
 However, CCC does not apply to companies that don’t have needs for inventory management . Software
companies that offer computer programs through licensing, for instance, can realize sales (and profits) without
the need to manage stockpiles.
 Businesses can have negative CCCs, like online retailers eBay Inc. (EBAY) and Amazon.com Inc. (AMZN ).
Often, online retailers receive funds in their account for sales of goods that actually belong to and are served by
third-party sellers who use the online platform. However, these companies don’t pay the sellers immediately
after the sale but may follow a monthly or threshold-based payment cycle.
 A Harvard Business blogpost attributes the negative CCC as a key factor in Amazon's survival of the dot-com
bubble of 2000. Operating with a negative CCC became a source of cash for the company, instead of being a
cost for it.

36
Profitability Ratios

Profitability Ratios
Definition

Profitability ratios measure a company’s ability to generate income relative to revenue, balance sheet
assets, operating costs, and equity.

Uses of Profitability ratio

Profitability ratio is used by investors to evaluate the company's ability to generate income as compared
to its expenses and other cost associated with the generation of income during a particular period. This
ratio represents the final result of the company.

Common profitability financial ratios include the following:

 Gross margin ratio 

 Operating margin ratio 
 Return on assets ratio
 Return on equity ratio 
 Profitability Ratios

Gross margin ratio 

The gross margin ratio compares the gross profit of a company to its net sales to
show how much profit a company makes after paying its cost of goods sold

Ideal Gross margin ratio = 65%

Operating margin ratio 

The operating margin ratio compares the operating income of a company to its net
sales to determine operating efficiency

Ideal Operating margin ratio

For most businesses, an operating margin higher
than 15% is considered good. It also helps to look at
trends in operating margin to see if past years indicate
that operating margin is going up or down.
Profitability Ratios

Return on assets ratio 

The return on assets ratio measures how efficiently a company is using its assets to
generate profit

Ideal Return on assets ratio

An ROA of 5% or better is typically considered

a good ratio while 20% or better is considered
great. In general, the higher the ROA, the more efficient the company is at generating profits.
 

Return on equity ratio 

The return on equity ratio measures how efficiently a company is using its equity to generate profit

Ideal Return on equity ratio

ROE is especially used for comparing the performance
of companies in the same industry. As with return on capital,
a ROE is a measure of management's ability to generate income
from the equity available to it. ROEs of 15–20% are generally
considered good.
Profitability Ratios

Return on Assets Ratio

In the Above Formula,

Net income is the amount of total revenue
that remains after accounting for all expenses for
production, overhead, operations, administrations,
debt service, taxes, amortization, and depreciation,
as well as for one-time expenses for unusual events
such as lawsuits or large purchases. Net profit also
accounts for any additional income not directly related
to primary operations, such as investment income or
one-time payments for the sale of equipment or other
assets.

40
Profitability Ratios

Return on Assets Ratio

Average Total Assets = (Opening Total Assets + Closing Total Assets) /
2

The total assets for 2017 were $349 billion (rounded)
The total assets for 2016 were $330 billion (rounded)
Exxon’s Total Average Assets =$339.5{(349+330​)​/ 2}

Exxon reported net income of $19.7 billion for 2017
Exxon’s ROA =($19.7 Billion / $339.5 Billion )  ​= 5.8%
41
 Profitability Ratios

Return on Assets Ratio

This means that for every dollar in assets during 2017, Exxon earned 5.8 cents in
profit

How To Know Whether it is good or bad?

Exxon's ROA is more meaningful when compared to other companies within the same
industry.
Here are the 2017 ROAs for comparable companies:
Chevron Corporation (CVX) ROA = 3.57%
British Petroleum (BP) ROA = 1.26%
By comparing Exxon's ROA to industry peers, we see that Exxon generated more profits
per dollar of assets than Chevron or BP in 2017.

Doesn’t ROA and ROE looks like same things?

Both ROA and return on equity (ROE) are measures of how a company utilizes its resources.
Essentially, ROE only measures the return on a company’s equity, leaving out the liabilities. Thus,
​
ROA accounts for a company’s debt and ROE does not. The more leverage and debt a company
takes on, the higher ROE will be relative to ROA.
42
Profitability Ratios

Return on Assets Ratio

Limitations of ROA
 The biggest issue with ROA is that it can't be used across industries. That’s because
companies in one industry, such as the technology industry, and another industry,
such as oil drillers, will have different asset bases.
 Some analysts also feel that the basic ROA formula is limited in its applications, being most
suitable for banks. Bank balance sheets better represent the real value of their assets and
liabilities because they’re carried at market value (via mark-to-market accounting), or at least an estimate of
market value, versus historical cost.
For non-financial companies, debt and equity capital is strictly segregated, as are the returns to each: interest expense
is the return for debt providers; net income is the return for equity investors. So the common ROA formula jumbles
things up by comparing returns to equity investors (net income) with assets funded by both debt and equity investors
(total assets).
Two variations on this ROA formula fix this numerator-denominator inconsistency by putting interest expense (net
of taxes) back into the numerator.
So the formulas would be:
ROA variation 1: Net Income + [Interest Expense*(1-tax rate)] / Total Assets
ROA variation 2: Operating Income*(1-tax rate) / Total Assets 43
 Valuation Ratios

Market Value Ratios

Definition

Market value ratios are used to evaluate the share price of a company’s stock.

Uses

Market value ratios are used to evaluate the current share price of a publicly-held company's stock.
These ratios are employed by current and potential investors to determine whether a company's shares are
over-priced or under-priced.

Common market value ratios include the following

Book value per share ratio

Dividend yield ratio 
Earnings per share ratio
Price-earnings ratio 
Valuation Ratios

Book value per share ratio

The book value per share ratio calculates the per-share value of a company based on the
equity available to shareholders:

Book value per share ratio = (Shareholder’s equity –

Preferred equity) / Total common shares outstanding
 
Dividend yield ratio
The dividend yield ratio measures the amount of dividends attributed to shareholders
relative to the market value per share:

Dividend yield ratio = Dividend per share / Share price

Valuation Ratios

Earnings per share ratio

The earnings per share ratio measures the amount of net income earned for each share
outstanding:

Earnings per share ratio = Net earnings / Total shares outstanding

Price-earnings ratio 
The price-earnings ratio compares a company’s share price to its earnings per share:

Price-earnings ratio = Share price / Earnings per share

 Valuation Ratios

Price/Earnings-to-Growth
​ Ratio
PEG Ratio= (Price / EPS) / EPS Growth;
In the above formula,
 Price represents the current Market price of the company
 EPS is the earnings per share of the company for the current year
arrived at by dividing profit after tax from Number of Shares
outstanding.
 EPS growth rate is arrived at by using analyst estimates available
on financial websites that follow the stock .When considering a
company's PEG ratio from a Finance website, Using historical
growth rates, may provide an inaccurate PEG ratio if future growth
rates are expected to deviate from a company's historical growth.
The ratio can be calculated using one-year, three-year, or five-year
expected growth rates.
To distinguish between calculation methods
using future growth and historical growth, the terms "forward PEG"
and "trailing PEG" are sometimes used.
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Valuation Ratios

Price/Earnings-to-Growth Ratio
Assume the following data for two hypothetical companies, Company
A and Company B:
Company A: Company B:
 Price per share = $46  Price per share = $80
 EPS this year = $2.09  EPS this year = $2.67
 EPS last year = $1.74  EPS last year = $1.78
Given this information, the following data can be calculated for each company .
Company A
 Company B
 P/E ratio = $46 / $2.09 = 22
 P/E ratio = $80 / $2.67 = 30
 Earnings growth rate = ($2.09 /
$1.74) - 1 = 20%  Earnings growth rate = ($2.67 / $1.78) - 1 = 50%

 PEG ratio = 22 / 20 = 1.1  PEG ratio = 30 / 50 = 0.6

Many investors may look at Company A and find it more attractive since it has a lower P/E ratio between the two
companies. But compared to Company B, it doesn't have a high enough growth rate to justify its P/E. Company B is
trading at a discount to its growth rate and investors purchasing it are paying less per unit of earnings growth. 48
Valuation Ratios

Price/Earnings-to-Growth Ratio
 The lower the PEG ratio, the more the stock may be undervalued given its future earnings
expectations. Adding a company's expected growth into the ratio helps to adjust the result for
companies that may have a high growth rate and a high P/E ratio.

 The degree to which a PEG ratio result indicates an over or underpriced stock varies by industry
and by company type. As a broad rule of thumb, some investors feel that a PEG ratio below one is
desirable.

 According to well-known investor Peter Lynch, a company's P/E and expected growth should be
equal, which denotes a fairly valued company and supports a PEG ratio of 1.0. When a company's
PEG exceeds 1.0, it's considered overvalued while a stock with a PEG of less than 1.0 is considered
undervalued.

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