Financial Ratios -- Profitability and Market Value Ratios

Uploaded by kevinbracker on 28.06.2012

This is the third and final video in our three part sequence on looking at
financial ratios
In the first video what we did is
took a look at
Pepsi's income statement, balance sheet, and statement of cash flows
from the guided tutorial handout
and again those financial statements are available online through Google docs
if you don't have the full handout
We gathered the necessary data to calculate our ratios
things from the balance sheet
income statement
statement cash flows
as well as a few extra items that we would need for some of our
So in the second
video, we went through take a look at the liquidity ratios -- things like the current
and quick ratio;
asset management ratios such as inventory turnover or total asset turnover;
and then
the debt management ratios things like
total debt to total assets or times interest earned.
In this third video we're going to take a look at profitability ratios
as well has
market value ratios.
Let's go ahead and start with some of our profitability ratios. We've got
several different ratios that we're going to use to take a look at profitability.
The first looks at the gross profit margin.
Gross profit margin looks at just how much is left over
after paying for our cost of goods sold. So we take sales minus cost of goods
divide by our sales
and record that as percentage.
So we go to our dataset.
We need that sales data
Sales are $66.504 billion
Remember all these values are in billions of dollars for Pepsi
and they come from the 2011 financial statements
So our gross profit margin
is equal to 66.504
Then we need to take out the cost of goods sold.
Cost of goods sold is $31.593 billion
and divide again by the sales which was $66.504 billion
So then we get our calculator
Go ahead and punch those values in 66.504

minus 31.593
five nine three
Divided by 66.504
and that gives us a gross profit margin of 52.49 percent.
And again, typically we don't want to write that down as a decimal, we want to write it down as a
So 52.49%
as our gross profit margin
Gross profit margins like
all of our profit margins are going to vary quite a bit from industry to industry
In order to make comparisons such as is this a good number or is it a bad number
what we really need to do is evaluate it to you industry standard. So we can
compare it to the industry average,
compare it to some of the major competitors
Another way to look at it is see what's happened over time --
trend analysis.
Has it been declining over the last few years in which case it's not as good
Or has it been trending up over the last few years in which case that same number will
look a little bit better.
As with all our ratios, context is key. We have to think about what the number means
and what is the story behind it as much as the actual number itself.
Next up we have our operating profit margin,
which pulls out not only our cost of goods sold but also our operating
Let's go ahead and calculate that
Operating profit margin
We need our operating income
Now sometimes you'll just have earnings before interest in taxes
and use that is operating income but in Pepsi's case they have both in operating
income and and earnings before interest in taxes, so if we've got that operating
income let's go ahead and use it
$9.633 was our operating income
and remember that's in billions
and our sales again
were $66.504 billion
we want to express that value as a percent so we're going to take
divided by 66.504
and that gives us 14.48 percent
for our operating profit margin
Now notice that's quite a bit below our gross profit margin. That's going to be the
case you're operating profit margin, because it pulls out more expenses
should always be below the
gross profit margin
and again we need that same context comparing to industry average or looking at
trends over time
to determine if that 14.48% is a good or bad number.
Our next way to describe profit margins
is the net profit margin
and this is probably the most commonly cited way to measure profit margin,
sometimes people just refer to it as profit margin
and not even bother with the net
strictly talking about profit margin
but because we have a gross and operating profit margins here
I want to make sure we clarified here we're talking about net profit margin
This is just net income --
what's left over after all our expenses.
Not just our cost of goods sold or operating expenses but also pulling out any taxes,
interest, all the expenses. What's left over as the bottom line
So our net profit margin -- we need net income
and I just realized in my collecting the data that was one piece of information
that I forgot to capture
So let me go back to the income statement for Pepsi
I've still got that handy

The net income
down here -- net income applicable to to common shares
for Pepsi
And remember these numbers are in thousands so that is $6.443 billion

So let me go ahead and add that that to my
Gathering the Data sheet
Income for Pepsi

$6.443 billion
So now I can use that to
calculate my net profit margin
over my sales
and we used that for our last couple ratios but just a reminder sales were
$66.504 billion
Do that calculation

divided by 66.504
gives us a net profit margin of 9.69%
Again, good or bad is all relative
the number itself doesn't tell us a whole lot. We've got to put it in the
context. Compare it to what Coca-Cola is doing; compared it to what Pepsi has done over
the last few years
Ideally we want to see that
trending up and better than the industry average. Now that's not going to happen all
the time, but that's the ideal situation we would like to see.
Different industries are going to have very different profit margins.
Retailers tend to have lower profit margins. Companies like software
companies often will have higher profit margins
That's going to vary a lot based on industry. That's why we really need
the context.
Then we've got return on assets
All these other
margins that we've been calculating and profitability ratios have been using sales as the
Now we're going to change it assets.
How well are we doing at using our assets to generate profits or net income.
In a way this is kind of like our asset management ratios but now instead of
using sales in the numerator
we're focusing on our assets.
How well are we doing at generating profits are net income
from those assets?
So our ROA
is equal to our net income,
which remember was $6.443 billion
divided by our assets
total assets from the balance sheet
$72.882 billion
Go ahead and do the calculation
divided by 72.882

And again we want to express that as a percent
so Pepsi's return on assets is 8.84%
Now our last profitability ratio
is going to be return on equity
which looks at how well the company is doing at generating net income based
on owners' equity
We want to be a little bit careful there
(the focus is going in and out -- hopefully that will fix it)
We want to be a little bit careful here with return on equity
this is not necessarily what the equity costs the new shareholder. This is what
the equity is
based on the accounting statements, kind of a book value measure
owners equity instead of a market value measure.
So return on equity is definitely useful information of how well the company is using
the shareholders assets, but for a new shareholder
or even existing shareholders thats looking at
what is the value of my
investment right now,
this common equity doesn't capture it as well as the current stock price.
So let's go ahead and calculate the return on equity
Return on equity is just our
net income again
$6.443 billion
divided by our
common equity, sometimes referred to has shareholders equity or owners equity.
And that is $20.704 billion.
And do our calculations
divided by 20.704
and that gives us 31.12%.
Now I want to come back to our
return on assets
and talk about that relative to our return on equity.
Remember our return on assets was 8.84%
The return on equity is 31.12% -- quite a bit of difference.
What drives that difference between the return of on assets and return on equity?
And I just realized that I need to
write ROE there and not ROA.
But, the return on equity
is always going to be greater than or equal to the return on assets
The reason that
is true is because it comes from financial leverage.
The greater the amount of debt financing we use,
the greater this differential is going to be.
If you remember from our second video when we were talking about Pepsi's
total debt to total assets ratio, we mentioned that was quite high. They were using quite a bit
of leverage.
That's why we see that huge differential here
between Pepsi's return on equity of 31.12%
and the return on assets of 8.84%
That's why I said we don't want to think of
told that the high total assets as bad
instead think of it is a risk level and as we increase our risk
we increase the potential
return from that investment.
So Pepsi is using lots of financial leverage to magnify their potential
returns to shareholders.
That's a riskier strategy but for a company like Pepsi that's got a very
stable, predictable cash flow stream, it's not quite as risky as it would be for some
other companies such as auto manufacturers
or maybe a pharmaceutical company that's
trying to develop some new
medication streams, things like that.
That covers our profitability ratios. The next thing that we want to look at is our market
value ratios.
Market value ratios are a way to look at it from the investors' perspective.
How expensive are how cheap is the stock?
What am I I earning as far as the dividend yield? Things like that.
The first ratio we're going to look at is the price-earnings ratio
Or oftentimes just referred to as the PE ratio or PE multiple
That PE
is just the market price
divided by the earnings per share -- so what is the current stock price
divided by the earnings per share
Now you can get the stock price from any number of places Yahoo!Finance,,
your broker,
Wall Street Journal ( There are tons of places that have that data.
I went ahead and used a historical price for this
from the end of 2011,
but you'd probably want to use whatever your current financial statements are and
a current stock price for this calculation.
Our market price is $66.35
and now we need the earnings per share
Now, we're not given the earnings per share in this calculation
instead we have the number of shares outstanding and our net income
So we have to calculate the earnings per share.
Earnings per share
is just the net income
divided by the
number of shares
Now a little side note --
technically it's a little more complex than that. We want to use the net income
available to common shareholders
and divide by a weighted average number of shares outstanding.
But for the purposes of our class we're just going to use a simple net income divided by
number of shares
So our net income was $6.443 billion
and the number of shares outstanding we had as 1.564 billion
Go ahead and calculate our earnings per share now
6.443 divided by 1.564
And that gives us an earnings per share of $4.12
So plug that into our
PE ratio formula
Stock price divided by earnings per share
Take the stock price of $66.35
divided by $4.12 earnings per share
And that gives us a PE ratio of 16.10
PE ratios are on of the more commonly cited ratios associated with stocks and stock
but it's a very difficult one to interpret. A lot of people
are a little bit
to lax with their PE ratio
and just say "Well high is expensive,
low is cheap."
But there are so many things that go into the price-earnings ratio
Is this last year's earnings or is it next year's forecast earnings?
How fast are earnings growing?
Lots of different things are going to affect that
And so we want to be really careful. Interest rates are going to affect that
PE ratio. The company's risk levels can affect that PE ratio.
So we want to be very careful when you're interpreting PE as to what the high or
expensive PE is or a low or cheap
PE is.
The next ratio we're going to look at is the market to book ratio
sometimes people refer to it as a market value-book value (MV/BV) ratio.
And again this is one that's going to
require us to take a couple intermediate steps
where you go ahead and start with the market price
which like we saw from our previous example is $66.35

But now we need the book value
Book value per share is just the owners equity or common equity
divided by the number of shares outstanding
So common equity divided by number of shares outstanding is going to give us our
book value
Go ahead and calculate
or go ahead and find our common equity
Common equity was given as 20.704 billion

and the number of shares outstanding
same as it was when we calculated our earnings per share
1.564 billion
shares outstanding
Go ahead and do that calculation

divided by 1.564
and that's going to give us a book value per share of $13.24.

That's the accounting value of the company
So from the balance sheet that's what the accountants are telling us each
share of stock is worth
Now that tends to understate the true value of the company. There are several reasons
for that.
One accounting does not do a great job of capturing the true value of intangible
That's not necessarily a fault of accounting, its by design. They try to be a
little more conservative.
Also accounting is based on historical cost for assets
not necessarily the market value those assets. So in most cases
book value is going to be less than the financial value or market value of the
So our market value to book value ratio will often be greater than one
How much greater is going to depend a lot on characteristics of the company.
So let's go ahead and calculate. We've got $66.35
divided by $13.24
gives us a market value
to book value ratio of 5.01
Again, does that mean the stock is cheap
or does that mean the stock is expensive?
It's hard to tell
That market value to book value ratio,
all else equal, the higher it is the more expensive the stock is.
The cheaper it is the more of a value the stock is. Sometimes you hear people refer
to value stocks versus growth stocks. Value stocks typically have a low
market value to book value ratio.
But just like the PE ratio there's lots of things that are going to
affect that.
Growth rates,
intangible assets, risk of the company -- all those things are going to determine
what that fair market value to book value should be
Lots of people use this ratio, but you want to be real careful in understanding
exactly what the ratio is telling us
and why you think that ratio is high or low
instead of just arbitrarily deciding well that's higher than the market
that's high
or that's lower the market average that's a cheap stock.
Our last ratio we're going to calculate is the dividend yield.
Dividend yield just looks at dividends per share divided by the market price.
Typically there are two ways investors turn rates of return from stocks. One is through
dividends and one is through capital gains.
Capital gains depends on the change in the stock price from when you purchase
it to when you sell it.
Well since we don't know what we're going to be able to sell it at, it's hard
to know exactly what our capital gains is
but our dividend yield is just based on what is the current value of the stock
and the dividends per share. How much are we making for owning the share divided
by its current value.
So when we calculate the dividend yield
we need to find the stock's dividends --
and here we had $2.03 on our dividends per share from
and our market price
Go ahead and calculate our dividend yield
$2.03 dividend divided by the $66.35 stock price

gives us a dividend yield of 3.06%.
Again is that good or bad?
The answer is it depends
Some companies, typically older companies or more stable
cash cow type companies
like a Pepsi are going to be able to pay out higher dividends. They are going to have a
little bit higher dividend yields
faster growing companies that are reinvesting a lot of their money into
the company are going to have lower dividend yields
But it's also going to vary depending on management strategy. Some companies prefer to use
stock buybacks return money to investors instead of pay dividends.
Lots of different things are gonna affect that dividend yield.
3.06%, as of the time recording that, is a
reasonably good dividend yield. It's not at the highest end; it's not at the
lowest end. It's a little bit above the current market average
and that makes sense for a company like
Pepsi. Again this is not your total rate of return from owning the stock but just
one component. The capital gain, or potentially capital loss if stock price
goes down, is also going to
determine your rate of return.
This should give you an overview of some of the ratios out there; how to calculate
them as well as some interpretation of the ratios. How do we use those ratios.
Again this is not designed to be a
complex, overly-sophisticated look at financial statement analysis.
Ratios are hard to use because there's a lot that goes into it.
Context is everything a lot of times people take a very simplistic view of
ratios --
think "well I can calculate some numbers and determine whether or not this is a
good company or a bad company from management or an investment perspective."
It's not that simple.
We have to know the story behind the numbers.
Ratios provide us a starting point they don't really give us -- this is a good
company or this is a bad company
Instead they say "Hey, here's something that needs to be looked at in a little more
detail...does this make sense?"
And they give us a starting point
to begin our analysis