Financial Ratio Tutorial

Cash Flow Indicator Ratios: Dividend Payout Ratio

This ratio identifies the percentage of earnings (net income) per common share allocated to paying cash dividends to shareholders. The dividend payout ratio is an indicator of how well earnings support the dividend payment.  
 
Here's how dividends "start" and "end." During a fiscal year quarter, a company's board of directors declares a dividend. This event triggers the posting of a current liability for "dividends payable." At the end of the quarter, net income is credited to a company's retained earnings, and assuming there's sufficient cash on hand and/or from current operating cash flow, the dividend is paid out. This reduces cash, and the dividends payable liability is eliminated.  
 
The payment of a cash dividend is recorded in the statement of cash flows under the "financing activities" section. 
 
Formula:

Components: 
Note: Zimmer Holdings does not pay a dividend. An assumed dividend amount, as of December 31, 2005, is provided to illustrate the ratio's calculation:

 
The numerator (annual report or Form 10-K) represents the annual dividend per share paid in cash and the denominator (income statement) represents the net income per share for FY 2005. 
 
Variations: 
At the bottom of the income statement, after the stated amount for net income (net earnings), the per share amounts for "basic" net income per common share and "diluted" net income per common share are provided. The basic per share amount does not take into consideration the possible effects of stock options, which would increase the number of shares outstanding. The diluted per share amount does take into account precisely this possible dilution. Conservative analysis would use the diluted net income per share figure in the denominator. 
 
In another version of the dividend payout ratio, total amounts are used rather than per share amounts. Nevertheless, an investor should arrive at the same ratio percentage.  
 
Note: In the U.K. there is a similar dividend payout ratio, which is known as "dividend cover". It's calculated using earnings per share divided by dividends per share. 
 
Commentary: 
Our first observation states the obvious - you only use this ratio with dividend-paying companies. Investors in dividend-paying stocks like to see consistent and/or gradually increasing dividend payout ratios. It should also be noted that exaggerated (i.e. very high) dividend ratios should be looked at skeptically.  
 
The question to ask is: Can the level of dividends be sustained? Many investors are initially attracted to high dividend-paying stocks, only to be disappointed down the road by a substantial dividend reduction (see remarks below). If this circumstance happens, the stock's price most likely will take a hit. 
 
Secondly, dividend payout ratios vary widely among companies. Stable, large, mature companies (i.e. public utilities and "blue chips") tend to have larger dividend payouts. Growth-oriented companies tend to keep their cash for expansion purposes, have modest payout ratios or choose not to pay dividends. 
 
Lastly, investors need to remember that dividends actually get paid with cash - not earnings. From the definition of this ratio, some investors may assume that dividend payouts imply that earnings represent cash, however, with accrual accounting, they do not. A company will not be able to pay a cash dividend, even with an adequate unrestricted balance in retained earnings, unless it has adequate cash.  
 
In view of this accounting treatment of dividends, it is incumbent upon investors to check a company's dividend payout ratio against an adequate margin of free cash flow to ensure that the payout percentage (ratio) is sustainable. 

This ratio identifies the percentage of earnings (net income) per common share allocated to paying cash dividends to shareholders. The dividend payout ratio is an indicator of how well earnings support the dividend payment.  
 
Here's how dividends "start" and "end." During a fiscal year quarter, a company's board of directors declares a dividend. This event triggers the posting of a current liability for "dividends payable." At the end of the quarter, net income is credited to a company's retained earnings, and assuming there's sufficient cash on hand and/or from current operating cash flow, the dividend is paid out. This reduces cash, and the dividends payable liability is eliminated.  
 
The payment of a cash dividend is recorded in the statement of cash flows under the "financing activities" section. 
 
Formula:

Components: 
Note: Zimmer Holdings does not pay a dividend. An assumed dividend amount, as of December 31, 2005, is provided to illustrate the ratio's calculation:

 
The numerator (annual report or Form 10-K) represents the annual dividend per share paid in cash and the denominator (income statement) represents the net income per share for FY 2005. 
 
Variations: 
At the bottom of the income statement, after the stated amount for net income (net earnings), the per share amounts for "basic" net income per common share and "diluted" net income per common share are provided. The basic per share amount does not take into consideration the possible effects of stock options, which would increase the number of shares outstanding. The diluted per share amount does take into account precisely this possible dilution. Conservative analysis would use the diluted net income per share figure in the denominator. 
 
In another version of the dividend payout ratio, total amounts are used rather than per share amounts. Nevertheless, an investor should arrive at the same ratio percentage.  
 
Note: In the U.K. there is a similar dividend payout ratio, which is known as "dividend cover". It's calculated using earnings per share divided by dividends per share. 
 
Commentary: 
Our first observation states the obvious - you only use this ratio with dividend-paying companies. Investors in dividend-paying stocks like to see consistent and/or gradually increasing dividend payout ratios. It should also be noted that exaggerated (i.e. very high) dividend ratios should be looked at skeptically.  
 
The question to ask is: Can the level of dividends be sustained? Many investors are initially attracted to high dividend-paying stocks, only to be disappointed down the road by a substantial dividend reduction (see remarks below). If this circumstance happens, the stock's price most likely will take a hit. 
 
Secondly, dividend payout ratios vary widely among companies. Stable, large, mature companies (i.e. public utilities and "blue chips") tend to have larger dividend payouts. Growth-oriented companies tend to keep their cash for expansion purposes, have modest payout ratios or choose not to pay dividends. 
 
Lastly, investors need to remember that dividends actually get paid with cash - not earnings. From the definition of this ratio, some investors may assume that dividend payouts imply that earnings represent cash, however, with accrual accounting, they do not. A company will not be able to pay a cash dividend, even with an adequate unrestricted balance in retained earnings, unless it has adequate cash.  
 
In view of this accounting treatment of dividends, it is incumbent upon investors to check a company's dividend payout ratio against an adequate margin of free cash flow to ensure that the payout percentage (ratio) is sustainable. 

Investment Valuation Ratios: Introduction

This last section of the ratio analysis tutorial looks at a wide array of ratios that can be used by investors to estimate the attractiveness of a potential or existing investment and get an idea of its valuation.  
 
However, when looking at the financial statements of a company many users can suffer from information overload as there are so many different financial values. This includes revenue, gross margin, operating cash flow, EBITDA, pro forma earnings and the list goes on. Investment valuation ratios attempt to simplify this evaluation process by comparing relevant data that help users gain an estimate of valuation. 
 
For example, the most well-known investment valuation ratio is the P/E ratio, which compares the current price of company's shares to the amount of earnings it generates. The purpose of this ratio is to give users a quick idea of how much they are paying for each $1 of earnings. And with one simplified ratio, you can easily compare the P/E ratio of one company to its competition and to the market. 
 
The first part of this tutorial gives a great overview of "per share" data and the major considerations that one should be aware of when using these ratios. The rest of this section covers the various valuation tools that can help you determine if that stock you are interested in is looking under or overvalued. 

Investment Valuation Ratios: Per Share Data

Before discussing valuation ratios, it's worthwhile to briefly review some concepts that are integral to the interpretation and calculation of the most commonly used per share indicators. 
 
Per-share data can involve any number of items in a company's financial position. In corporate financial reporting - such as the annual report, Forms 10-K and 10-Q (annual and quarterly reports, respectively, to the SEC) - most per-share data can be found in these statements, including earnings and dividends.  
 
Additional per-share items (which are often reported by investment research services) also include sales (revenue), earnings growth and cash flow. To calculate sales, earnings and cash flow per share, a weighted average of the number of shares outstanding is used. For book value per share, the fiscal yearend number of shares is used. Investors can rely on companies and investment research services to report earnings per share on this basis. 
 
In the case of earnings per share, a distinction is made between basic and diluted income per share. In the case of the latter, companies with outstanding warrants, stock options, and convertible preferred shares and bonds would report diluted earnings per share in addition to their basic earnings per share.  
 
The concept behind this treatment is that if converted to common shares, all these convertible securities would increase a company's shares outstanding. While it is unlikely for any or all of these items to be exchanged for common stock in their entirety at the same time, conservative accounting conventions dictate that this potential dilution (an increase in a company's shares outstanding) be reported. Therefore, earnings per share come in two varieties - basic and diluted (also referred to as fully diluted). 
 
An investor should carefully consider the diluted share amount if it differs significantly from the basic share amount. A company's share price could suffer if a large number of the option holders of its convertible securities decide to switch to stock. 
 
For example, let's say that XYZ Corp. currently has one million shares outstanding, one million in convertible options outstanding (assumes each option gives the right to buy one share), and the company's earnings per share are $3. If all the options were exercised (converted), there would be two million shares outstanding. In this extreme example, XYZ's earnings per share would drop from $3 to $1.50 and its share place would plummet. 
 
While it is not very common, when companies sell off and/or shut down a component of their operations, their earnings per share (both basic and diluted) will be reported with an additional qualification, which is presented as being based on continuing and discontinued operations. 
 
The absolute dollar amounts for earnings, sales, cash flow and book value are worthwhile for investors to review on a year-to-year basis. However, in order for this data to be used in calculating investment valuations, these dollar amounts must be converted to a per-share basis and compared to a stock's current price. It is this comparison that gives rise to the common use of the expression "multiple" when referring to the relationship of a company's stock price (per share) to its per-share metrics of earnings, sales, cash flow and book value. These so-called valuation ratiosprovide investors with an estimation, albeit a simplistic one, of whether a stock price is too high, reasonable, or a bargain as an investment opportunity. 
 
Lastly, it is very important to once again to remind investors that while some financial ratios have general rules (or a broad application), in most instances it is a prudent practice to look at a company's historical performance and use peer company/industry comparisons to put any given company's ratio in perspective. This is particularly true of investment valuation ratios. This paragraph, therefore, should be considered as an integral part of the discussion of each of the following ratios.

 
Investment Valuation Ratios: Price/Book Value Ratio

A valuation ratio used by investors which compares a stock's per-share price (market value) to its book value (shareholders' equity). The price-to-book value ratio, expressed as a multiple (i.e. how many times a company's stock is trading per share compared to the company's book value per share), is an indication of how much shareholders are paying for the net assets of a company.  
 
The book value of a company is the value of a company's assets expressed on the balance sheet. It is the difference between the balance sheet assets and balance sheet liabilities and is an estimation of the value if it were to beliquidated.  
 
The price/book value ratio, often expressed simply as "price-to-book", provides investors a way to compare the market value, or what they are paying for each share, to a conservative measure of the value of the firm.  
 
Formula:

 
Components:

  
The dollar amount in the numerator, $67.44, is the closing stock price for Zimmer Holdings as of December 30, 2005, as reported in the financial press or over the Internet in online quotes. In the denominator, the book value per share is calculated by dividing the reported shareholders' equity (balance sheet) by the number of common shares outstanding (balance sheet) to obtain the $18.90 book value per-share figure. By simply dividing, the equation gives us the price/book value ratio indicating that, as of Zimmer Holdings' 2005 fiscal yearend, its stock was trading at 3.6-times the company's book value of $18.90 per share. 
 
Variations: 
A conservative alternative to using a company's reported shareholders' equity (book value) figure would be to deduct a company's intangible assets from its reported shareholders' equity to arrive at a tangible shareholders' equity (tangible book value) amount. For example, Zimmer Holdings' FY 2005 balance sheet reports goodwill (in millions $) of $2,428.8 and net intangible assets of $756.6, which total $3,185.4. If we deduct these intangible assets from its shareholders' equity of $4,682.8 of the same date, Zimmer Holdings is left with a significantly reduced tangible shareholders' equity of $1,497.4. Factoring this amount into our equation, the company has a book value per share of only $6.04, and the price/book value ratio then skyrockets to 11.2 times. 
 
Commentary: 
If a company's stock price (market value) is lower than its book value, it can indicate one of two possibilities. The first scenario is that the stock is being unfairly or incorrectly undervalued by investors because of some transitory circumstance and represents an attractive buying opportunity at a bargain price. That's the way value investors think. It is assumed that the company's positive fundamentals are still in place and will eventually lift it to a much higher price level.  
 
On the other hand, if the market's low opinion and valuation of the company are correct (the way growth investorsthink), at least over the foreseeable future, as a stock investment, it will be perceived at its worst as a losing proposition and at its best as being a stagnant investment. 
 
Some analysts feel that because a company's assets are recorded at historical cost that its book value is of limited use. Outside the United States, some countries' accounting standards allow for the revaluation of the property, plant and equipment components of fixed assets in accordance with prescribed adjustments for inflation. Depending on the age of these assets and their physical location, the difference between current market value and book value can be substantial, and most likely favor the former with a much higher value than the latter.  
 
Also, intellectual property, particularly as we progress at a fast pace into the so-called "information age", is difficult to assess in terms of value. Book value may well grossly undervalue these kinds of assets, both tangible and intangible. 
  
The P/B ratio therefore has its shortcomings but is still widely used as a valuation metric. It is probably more relevant for use by investors looking at capital-intensive or finance-related businesses, such as banks. 
 
In terms of general usage, it appears that the price-to-earnings (P/E) ratio is firmly entrenched as the valuation of choice by the investment community. (Skip ahead to the P/E chapter here.) 

Investment Valuation Ratios: Price/Cash Flow Ratio

he price/cash flow ratio is used by investors to evaluate the investment attractiveness, from a value standpoint, of a company's stock. This metric compares the stock's market price to the amount of cash flow the company generates on a per-share basis. 
 
This ratio is similar to the price/earnings ratio, except that the price/cash flow ratio (P/CF) is seen by some as a more reliable basis than earnings per share to evaluate the acceptability, or lack thereof, of a stock's current pricing. The argument for using cash flow over earnings is that the former is not easily manipulated, while the same cannot be said for earnings, which, unlike cash flow, are affected by depreciation and other non-cash factors.  
 
Formula:

 
Components: 
                   

The dollar amount in the numerator is the closing stock price for Zimmer Holdings as of December 30, 2005 as reported in the financial press or over the Internet in online quotes. In the denominator, the cash flow per share is calculated by dividing the reported net cash provided by operating activities (cash flow statement) by the weighted average number of common shares outstanding (income statement) to obtain the $3.55 cash flow per share figure. By simply dividing, the equation gives us the price/cash flow ratio that indicates as of Zimmer Holdings' 2005 fiscal yearend, its stock (at $67.44) was trading at 19.0-times the company's cash flow of $3.55 per share. 
 
Variations: 
Sometimes free cash flow is used instead of operating cash flow to calculate the cash flow per share figure. 
 
Commentary: 
Just as many financial professionals prefer to focus on a company's cash flow as opposed to its earnings as a profitability indicator, it's only logical that analysts in this camp presume that the price/cash flow ratio is a better investment valuation indicator than the P/E ratio. 
 
Investors need to remind themselves that there are a number of non-cash charges in the income statement that lower reported earnings. Recognizing the primacy of cash flow over earnings leads some analysts to prefer using the P/CF ratio rather than, or in addition to, the company's P/E ratio. 
 
Despite these considerations, there's no question that the P/E measurement is the most widely used and recognized valuation ratio. 

Investment Valuation Ratios: Price/Earnings Ratio

The price/earnings ratio (P/E) is the best known of the investment valuation indicators. The P/E ratio has its imperfections, but it is nevertheless the most widely reported and used valuation by investment professionals and the investing public. The financial reporting of both companies and investment research services use a basic earnings per share (EPS) figure divided into the current stock price to calculate the P/E multiple (i.e. how many times a stock is trading (its price) per each dollar of EPS). 
 
It's not surprising that estimated EPS figures are often very optimistic during bull markets, while reflecting pessimism during bear markets. Also, as a matter of historical record, it's no secret that the accuracy of stock analyst earnings estimates should be looked at skeptically by investors. Nevertheless, analyst estimates and opinions based on forward-looking projections of a company's earnings do play a role in Wall Street's stock-pricing considerations.  
 
Historically, the average P/E ratio for the broad market has been around 15, although it can fluctuate significantly depending on economic and market conditions. The ratio will also vary widely among different companies and industries. 
 
Formula: