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108-Learn the Lingo--Basic Ratios
  Course 108:
  Learn the Lingo--Basic Ratios
  Now that you've learned the basics of reading financial statements (the
  language of business), let's learn the basic language of investing.
  
  Ratios are a common tool investors use to relate a stock's price with an
  element of the underlying company's performance. These quick and dirty ratios
  can be useful in their own way, as long as you're aware of the limitations.
  
  But before we get to calculating any ratios, we must first cover some
  essential definitions.
  
  
  Earnings Per Share
  Earnings per share (EPS) is a company's net income (typically over the
  trailing 12 months) divided by its number of shares outstanding. EPS comes in
  two varieties, basic and diluted. Basic EPS includes only actual outstanding
  shares of a company's stock, while diluted EPS represents all potential stock
  that could be outstanding with current stock option grants and the like.
  Diluted EPS is the more "conservative" number.
  
  EPS = (Total Company Earnings) / (Shares Outstanding)
  
  Although EPS can give you a quick idea of a company's profitability, it should
  not be used in isolation without also looking at cash flow and other
  performance metrics.
  
  
  Market Capitalization
  Market capitalization is essentially the market value of a company. It is
  calculated by multiplying the number of shares outstanding by the current
  share price. For example, if there are 10 million shares outstanding of ABC
  Corporation and ABC's stock is currently trading at $25 per share, the market
  capitalization of ABC is $250 million. As we will find out shortly, market
  capitalization not only gives you an idea concerning the size of a company, it
  can also be used when calculating the basic valuation ratios.
  Market Capitalization = (Stock Price) x (Shares Outstanding)
  
  
  Profit Margins
  Just as there are three types of profits--gross, operating, and net--there are
  also three types of profit margins that can be calculated to offer insight
  into a company's profitability. Gross margin is simply gross profits divided
  by revenues, and so on. Margins are usually stated in percentages.
  Gross Margin = (Gross Profits) / Revenues
  Operating Margin = (Operating Profits) / Revenues
  Net Margin = (Net Profits) / Revenues
  
  
  Price/Earnings and Related Ratios
  One of the most popular valuation measures is the price/earnings ratio, or
  P/E. The P/E is the price of a stock divided by its EPS from the trailing four
  quarters. As an example, a stock trading for $15 per share with earnings of $1
  per share during the past year has a P/E of 15.
  
  P/E = (Stock Price) / EPS
  
  The P/E ratio gives a rough idea of the price investors are paying for a stock
  relative to its underlying earnings. It is a quick and dirty way to gauge how
  cheap or expensive a stock may be. Generally, the higher the P/E ratio, the
  more investors are willing to pay for a dollar's worth of earnings from a
  company. High P/E stocks (typically those with a P/E above 30) tend to have
  higher growth rates and/or the expectation of a profit turnaround. Meanwhile,
  low P/E stocks (typically those with a P/E below 15) tend to have slower
  growth and/or lesser future prospects.
  
  The P/E ratio can also be useful when compared with the P/Es of similar
  companies to see how the competitors stack up. In addition, you can compare a
  company's P/E with the average P/E of the S&P 500 or some other benchmark
  index to get a rough idea of how richly a stock is valued relative to the
  broader market.
  
  One useful variant of P/E is earnings yield, or EPS divided by the stock
  price. Earnings yield is the inverse of P/E, so a high earnings yield
  indicates a relatively inexpensive stock while a low earnings yield indicates
  a more expensive one. It can be useful to compare earnings yields with 10- or
  30-year Treasury bond yields to get an idea of how expensive a stock is.
  
  Earnings Yield = 1 / (P/E ratio) = EPS / (Stock Price)
  
  Another useful variant of P/E is the PEG ratio. A high P/E generally means
  that the market expects the company to grow its profits rapidly in the future,
  so a much greater percentage of the company's potential earnings are in the
  future. This means its market value (which reflects those future earnings) is
  large relative to its present-day earnings.
  The PEG ratio can help you determine if a stock's P/E has gotten too high in
  these cases by giving you an idea of how much investors are paying for a
  company's growth. A stock's PEG ratio is its forward P/E divided by its
  expected earnings growth over the next five years as predicted by a consensus
  of Wall Street estimates. For example, if a company has a forward P/E of 20
  with annual earnings estimated to grow 10% per year on average, its peg ratio
  is 2.0. Again, the higher the peg ratio, the more relatively expensive a stock
  is.
  
  PEG = (Forward P/E Ratio) / (5-Year EPS Growth Rate)
  
  As with other measures, the PEG ratio should be used with caution. PEG relies
  on two different Wall Street analyst estimates--next year's earnings and
  five-year earnings growth--and thus is doubly subject to the possibility of
  overly optimistic or pessimistic analysts. It also breaks down at the extremes
  of zero-growth or hyper-growth companies.
  
  
  
  Price/Sales Ratio
  Another common valuation measure is the price/book ratio (P/B), which relates
  a stock's market value with its book value (also known as shareholder equity)
  from the latest balance sheet. Book value can be thought of as what would be
  left over for shareholders if a company shutters operations, pays off its
  creditors, collects from its debtors, and liquidates itself.
  
  Book Value Per Share = (Total Shareholders Equity) / (Shares Outstanding)
  
  P/B = (Stock Price) / (Book Value Per Share) = (Market Capitalization) /
  (Total Shareholder Equity)
  
  As with the other ratios we've covered so far, there are caveats to using P/B.
  For instance, book value may not accurately measure a company's worth,
  especially if the firm possesses significant intangible assets such as brand
  names, market share, and other competitive advantages. The lowest price/book
  ratios tend to be in capital-intensive industries such as utilities and
  retail, whereas the highest P/B ratios are in fields such as pharmaceuticals
  and consumer products, where intangibles are more important.
  
  Price/book is also tied to return on equity (ROE), which is net income divided
  by shareholder equity. Given two companies that are otherwise equal, the one
  with the higher ROE will have a higher P/B ratio. A high P/B shouldn't be
  cause for alarm, especially if the company continually earns a high ROE.
  
  
  The price/sales (P/S) ratio is figured the same way as P/E, except with a
  company's annual sales as the denominator instead of its earnings. An
  advantage to using the P/S ratio is that it is based on sales, a figure that
  is much harder to manipulate and is subject to fewer accounting estimates than
  earnings. Also, because sales tend to be more stable than earnings, P/S can be
  a good tool for screening cyclical companies and other companies with
  fluctuating earnings patterns.
  
  P/S = (Stock Price) / (Sales Per Share) = (Market Capitalization) / (Total
  Sales)
  
  When using the P/S ratio, it is important to keep in mind that a dollar of
  earnings has essentially the same value regardless of the level of sales
  needed to create it. Meaning, a dollar of sales at a highly profitable firm is
  worth more than a dollar of sales for a company with narrow profit margins.
  This means comparing price/sales is generally useful only when comparing
  companies in similar industries.
  
  To understand the differences across industries, let's compare grocery stores
  with the medical-device industry. Grocery stores tend to have very small
  profit margins, earning only a few pennies on each dollar of sales. As such,
  grocers have an average P/S ratio of 0.5, one of the lowest in Morningstar's
  coverage universe. It takes a lot of sales to create a dollar of earnings at a
  grocery store, so investors do not value those sales dollars very highly.
  
  Meanwhile, medical-device makers have much fatter profit margins. Relative to
  the grocer, it does not take nearly as much in sales for a medical-device
  company to create a dollar in earnings. It is little wonder the device makers
  have a high average price/sales ratio of 5.0. A grocer with a P/S ratio of 2.0
  would look quite expensive while a medical-device maker with the same P/S
  could be dirt-cheap.
  
  
  Price/Cash Flow
  The price/cash flow (P/CF) ratio is not as commonly used or as well known as
  the other measures we've discussed. It's calculated similarly to P/E, except
  that it uses operating cash flow instead of net income as the denominator.
  
  P/CF = (Stock Price) / (Operating Cash Flow Per Share)
  
  Cash flow can be less subject to accounting shenanigans than earnings because
  it measures actual cash, not paper or accounting profits. Price/cash flow can
  be helpful for firms such as utilities and cable companies, which can have
  more cash flow than reported earnings. Price/cash flow can also be used in
  place of P/E when there are so many one-time expenses that reported earnings
  are negative.
  
  
  Dividend Yield
  There are two ways to make money when buying a stock--capital gains (when a
  stock goes up in price) and dividend payments. Dividends are payments that
  companies make directly to shareholders.
  
  Dividend yield has been an important measure of valuation for many years. The
  dividend yield is equal to a company's annual dividend per share divided by
  its stock price per share. So, if a company pays an annual dividend of $2.00
  and has a stock that trades for $100, its dividend yield is 2.0%. If that same
  stock's price fell to $50 per share, its dividend yield would rise to 4.0%.
  Conversely, all else equal, the dividend yield falls when a stock's price goes
  up.
  
  Dividend Yield = (Annual Dividends Per Share) / (Stock Price)
  
  Stocks with high dividend yields are generally mature companies with few
  growth opportunities. The economic reasoning behind this is that these
  companies can't find enough promising projects to invest in for future growth,
  so they pay a larger portion of profits back to shareholders. While utility
  companies are considered the typical dividend-paying stocks, you can also find
  dividends in sectors with lots of room left for growth such as the
  pharmaceutical industry.
  
  Dividends have recently begun to garner investors' attention again. A big
  driver of this new focus was a recent change in the United States tax code
  that lowered the tax rate on dividends. So if you are looking for dividend
  income from your stock investments, remember that the best high-yielding
  stocks have strong cash flows, healthy balance sheets, and relatively stable
  businesses. And, if you're relying on that stream of dividends for income,
  checking for a steady history of dividend payments is also a good idea.
  
  
  The Bottom Line
  We've gone over how to calculate a lot of ratios in this lesson, but
  understanding the components of these ratios is key to learning the lingo of
  investors. It is also essential in beginning to understand when a stock is
  cheap or expensive. The good news is that if you invest long enough, the
  ratios highlighted here will become second nature.