Investment and
Portfolio Management
WEEK ONE
Course Administration
Professor Thomas Davis
Email: tomas.davis@hotmail.com
Student course leader
Textbook: online links provided with each PPT
Course Assessment
30% midterm exam (5 Oct-22 Oct)
20% project (around 8 Nov)
50% final exam (30 Nov-17 Dec)
Course Outline
Introduction (week 1)
Investments, taxes, and indexes (week 2)
Securities trading (week 3)
Securitization and the 2008 financial crisis (week 4)
Risk and return (week 5)
Case study (week 6)
Review for midterm exam (week 7)
Course Outline
Asset allocation/expected return (week 8)
Bond pricing/bond yields (week 9)
Equity valuation (week 10)
Case study (week 11)
Financial statement analysis (week 12)
Case study (week 13)
Review for final exam (week 14)
Investment and
Portfolio Management
xx
WEEK TWO
Readings
Financial services
https://answers.yahoo.com/question/index?qid=1006032905285
http://www.wikijob.co.uk/wiki/investment-management-vs-investment-banking
Taxes and investments
https://us.axa.com/investing/mutual-funds/tax-free-or-taxable-mutual-funds.html
Index calculations
http://www.investopedia.com/articles/02/082702.asp
Asset allocation
http://www.sec.gov/investor/pubs/assetallocation.htm
Real vs. Financial Assets
Real assets generate income
Financial assets allocate income
Financial assets we will discuss in this class:
Fixed income securities
Equity securities
Derivatives
Financial Services Industry
Investment banking (“sell side”)
Underwriting and securities sales
Transaction-oriented
Asset management (“buy side”)
Investment selection
Relationship-oriented
Financial Markets and the Economy
Diversification of risk
Limited liability
Separation of ownership and management
Corporate governance and ethics
The Investment Process
Asset allocation
Fixed income vs. equity
Domestic vs. international
High risk vs low risk
Active vs. passive asset management
Security analysis
Security selection
Tax Effects – Interest Income
After-tax return calculation
After-tax return = Pre-tax return x (1 – tax rate)
Which investment provides a higher after-tax return:
Taxable bond, 8.0% coupon
Tax-free bond, 7.5% yield
Investor marginal tax rate: 15%
Tax Effects – Interest Income
Investment
Taxable bonds
Tax-free bonds
After-tax return difference in basis points
Coupon rate
8.00%
7.50%
After-tax
Tax rate
return
15%
6.80%
N/A
7.50%
70
Tax Effects – Dividends vs. Capital Gains
Dividend income is short-term income
Capital gain income is (usually) long-term income
Which investment provides a higher after-tax return:
Buy 100 shares at $40, receive $2.00 dividend, sell at $45
Buy 100 shares at $40, receive no dividend, sell at $47
Tax rates: 25% on dividends, 15% on capital gains
Tax Effects – Dividends vs. Capital Gains
Taxes
Investment
Buy Price Dividend Sell Price Investment Dividends Proceeds
Dividends Capital Gains Net Proceeds Net Return
Dividend stock
$
40.00 $ 2.00 $ 45.00 $
4,000 $
200 $ 4,500 $
50 $
75 $
4,575
14.38%
Non-dividend stock
$
40.00 $ $ 47.00 $
4,000 $
$ 4,700 $
$
105 $
4,595
14.88%
After-tax return difference in basis points
0.50
Market Indexes
Price-weighted index: the weight of each security in
the index is based on share price
Market-weighted index: the weight of each security
in the index is based on total market value
If a small company has a high share price, what
happens?
Price-Weighted Index – Example
ABC (a large company) starts at $25 a share and
increases to $30. XYZ (a small company) starts at
$100 and falls to $90. What is the initial index, the
final index, and the % change?
If XYZ does a two for one stock split before the price
change, what is the initial index, the final index, and
the % change?
Price-Weighted Index – Calculation
Stock
ABC
XYZ
Total
Divisor
Index
Index Value
Old
New
25.00
30.00
100.00
90.00
125.00
120.00
2.00
2.00
62.5
60.0
With XYZ Stock Split
Index Value
Stock
Old
New
ABC
25.00
30.00
XYZ
50.00
45.00
Total
75.00
75.00
Index
62.5
62.5
Divisor
1.20
1.20
% Change
20.0%
-10.0%
-4.0%
% Change
20.0%
-10.0%
0.0%
Price-Weighted Index – What Happened?
Even though XYZ is a small company, because the
price-weighted index only considers the price “size”
and not the company size, a high stock price has
more weight than a low stock price, regardless of
actual market value.
If ABC has 20mm shares outstanding, and XYZ has
1mm shares outstanding, with an initial index of 100,
what is the ending index and the % change?
Market-Weighted Index – Calculation
Stock
ABC
XYZ
Total
Index
Stock Price
Market Value (mm)
Old
New Shares (mm)
Old
New
$ 25.00 $ 30.00
20 $ 500 $ 600
$ 100.00 $ 90.00
1 $ 100 $
90
$ 600 $ 690
100
115
Investment and
Portfolio Management
WEEK THREE
Readings
Trading
https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=12&cad=rja&uact=8&ved=0CFsQFjAL&url=http%3A%2F%2F
www.umsl.edu%2F~fungh%2FTSYSTEM.PPT&ei=S2H4U6DNCsT8ywOEoYGgBQ&usg=AFQjCNEtwwVUkr66qnI_5IfviFZlr8fcw&bvm=bv.73612305,d.bGQ
Margin
http://www.investopedia.com/university/margin/margin1.asp
Margin and Islamic finance
http://www.bloomberg.com/news/2014-08-17/u-a-e-margin-trade-crackdown-fans-shariah-push-islamic-finance.html
Short sales
http://www.investopedia.com/university/shortselling/shortselling1.asp
Mutual funds
http://www.fool.com/School/MutualFunds/Basics/Intro.htm
This is an 11- part series, the links for all 11 parts on the right side of the screen. You don’t need to read these for class, but if you
are interested in learning more about mutual funds they are informative.
How Securities are Traded
Issuing securities – investment banking function
Trading/securities markets – NYSE, NASDAQ, etc.
Trading costs
Broker fees – direct cost
Dealer bid-ask spread – indirect cost
Margin – investing with debt
Short sales – sell before you buy!
Margin Analysis
What is the annualized leveraged return on a sixmonth investment of $100,000 which returns 12%
and is purchased at 60% margin with an interest rate
of 16%?
What is the annualized leveraged return if the
investment yields 2%?
Margin Analysis
Scenario
Investment
Margin
Equity
Debt
Investment return
Less: cost of debt *
Net change
Ending equity
Investment return
Annualized return
$
$
$
$
8% $
$
$
12%
100,000 $
60%
60,000 $
40,000 $
12,000
(3,200)
8,800
68,800
$
$
$
$
14.7%
29.3%
* - i nteres t ra te: 16%/12 months = 1.33% * 6 months = 8%
2%
100,000
60%
60,000
40,000
2,000
(3,200)
(1,200)
58,800
-2.0%
-4.0%
Short Sales
Strategy for anticipated stock price decline
Short sale example:
Borrow 1,000 shares of Blue Co., sell for $45/share
Stock price declines from $45 to $42
Buy 1,000 shares for $42/share to repay borrowings
Profit: $45-$42 = $3/share * 1,000 = $3,000 (less fees)
Stock prices increase = loss for short seller
Mutual Funds
Administration
Diversification
Professional management
Lower transaction costs
Mutual Fund Valuation
Net asset value (NAV) = (assets-liabilities) / shares
Rate of return = (NAV1-NAV0 + distributions) / NAV0
Net returns = rate of return – expense ratio
Mutual Fund Valuation Example
What is the net asset value of a mutual fund with a
portfolio of securities worth $120mm, liabilities of
$5mm, and 5mm shares outstanding?
What is the rate of return of the mutual fund if the
NAV was $20.45 one year ago and the distributions
during the year were $0.70/share?
What is the net return if the expense ratio is 1.2%?
Mutual Fund Valuation Example
Assets, Liabilities,
mm
mm
$
120 $
5
$
NAV1
23.00 $
Return
15.89%
Shares
NAV
5,000,000 $ 23.00
NAV0 Distributions
20.45 $
0.70
Expense
Ratio
1.20%
Return
15.89%
Net Return
14.69%
Investment and
Portfolio Management
WEEK FIVE
Readings
Real vs. nominal interest rates
http://www.moneycrashers.com/nominal-vs-real-interest-ratescalculate-inflation/
Standard deviation
http://ci.columbia.edu/ci/premba_test/c0332/s6/s6_4.html
Why Do Investors Accept Risk?
Investors decide on the best investment option based
on their risk/return profile.
The alternative to a risky investment is not “no
investing”, rather it is to invest in risk-free assets such
as US T-bills or money market funds.
Thus, investors accept risk for the potential to realize
excess return over risk-free investments.
Why Do Investors Accept Risk?
If the risk free rate is 2.5%, and an investor selects an
investment with a potential return of 20%, what is the
excess return he is seeking in exchange for risk?
20%? No!
20% - 2.5% = 17.5% = excess return
Real/Nominal Interest Rates
Real interest rate is adjusted for inflation
Real interest rate = nominal rate – inflation
If the nominal rate on an investment is 8% and
inflation is 5%, what is the real interest rate?
8% - 5% = 3% real interest rate
Holding Period Returns
HPR =
(ending share price – beginning price + dividends) / beginning price
What is the HPR of an investment at $10.00/share
under the following scenarios:
Ending price $12.00, dividend $0.30
Ending price $10.25, dividend $0.30
Ending price $9.00, no dividend
Holding Period Returns
(12 – 10 + .30) / 10 = 23%
(10.25 – 10 + .30) / 10 = 5.5%
(9 – 10 + 0) / 10 = -10%
Which return will be the actual return? We don’t know.
So how do we quantify the uncertainty of actual returns?
By calculating standard deviation.
Standard Deviation
Standard deviation is the variation in returns
calculated by comparing the average return to the
range of individual returns.
The wider the variation in returns, the higher the
standard deviation and the higher the uncertainty
4%,4.5%, 4.9%: low uncertainty
-8%, 4%, 24%: high uncertainty
Standard Deviation
A “normal distribution” provides the following
ranges:
One standard deviation = 68% probability range
Two standard deviations = 95% probability range
Three standard deviations = 99.7% probability range
If the mean return on a group of investments is 12%,
and the standard deviation is 0.8%, what are the
ranges of return at 1, 2, and 3 standard deviations?
Standard Deviation
12% +/- 0.8%*1 = 11.2% to 12.8% = 68% probability
12% +/- 0.8%*2 = 10.4% to 13.6% = 95% probability
12% +/- 0.8%*3 = 9.6% to 14.4% = 99.7% probability
Thus, the probability of realizing a return greater than
14.4% or less than 9.6% is 0.3%.
Unlikely… but not impossible!
Coefficient of Variance
Coefficient of variance (COV) shows the relationship
between risk and expected return.
COV = standard deviation/expected return
In comparing two investments, the investment with
the lower coefficient of variance offers more return for
less risk.
Return Calculation Assumptions
The normal curve is a simplifying assumption
For some investments, extreme losses have a higher
probability than extreme gains.
For some investments, the possibility of returns outside
of 3 standard deviations is much higher than 0.3%.
Return estimates and standard deviation calculations
are based on analysis of historical data, but the
present is not the same as the past!
Investment and
Portfolio Management
WEEK EIGHT
Capital Allocation Options
Risk-free assets
US treasury bills
Money market funds
Risky assets
Stocks
Bonds
Allocation Decision
First stage: allocation between risk-free and risky assets
Second stage: allocation among risky assets
Capital Allocation Example
Portfolio value: $300,000
First stage decision
30% risk-free = $90,000
70% risky assets = $210,000
Second stage decision (allocation of risky assets)
54% equity = $113,400 ($210,000 * 54%)
46% bonds = $96,600 ($210,000 * 46%)
Capital Allocation Adjustment
Portfolio value: $300,000
First stage decision
40% risk-free = $120,000
60% risky assets = $180,000
Second stage decision (allocation of risky assets)
54% equity = $97,200 ($180,000 * 54%)
46% bonds = $82,800 ($180,000 * 46%)
Capital Allocation Adjustment
In each allocation, the complete portfolio allocation changes,
so the risk profile of the complete portfolio changes.
Within the allocations, the risky portfolio allocation does not
change, so the risk profile of the risky portion of the portfolio
does not change.
For analysis purposes, since we are analyzing an unchanging
risky portfolio, we can think about this portion of the portfolio
as if it were one asset, and we are only considering one
decision, which is the allocation between the risk-free asset
and the risky asset.
Expected Portfolio Return Calculations
Complete portfolio return =
risk-free rate + risky asset weighting * risk premium
Standard deviation =
risky asset weighting * SD
Expected Return and Standard Deviation
Risky asset weighting: 65%
Risk-free asset weighting: 35%
Risk-free rate: 7%
Risk premium: 8%
Standard deviation of risky asset: 22%
Expected Return Example
Expected portfolio return =
7% + 65% * 8% = 12.20%
Standard deviation =
65% * 22% = 14.30%
Expected Return Exercise
What is the expected return and standard deviation of
this portfolio if we change the weighting to 60% invested
in a risk-free asset and 40% invested in a risky asset?
Expected Return Example
Expected portfolio return =
7% + 40% * 8% = 10.20%
Standard deviation =
40% * 22% = 8.80%
Leveraged Portfolio
What is the expected return and standard deviation of
this portfolio if we change the weighting to 100%
invested in a risky asset, and we fund the portfolio with
60% equity and 40% debt?
The risk-free “asset” is represented by the debt, and the
risk-free asset weighting is negative, so when we
calculate the risky asset weighting, it is more than 100%.
Leveraged Portfolio Return Calculation
The risky asset weighting is: 1/60% = 167%
Expected portfolio return =
7% + 167% * 8% = 20.33%
Standard deviation =
167% * 22% = 36.74%
The effect of leverage is the opposite of the effect of investing
in a risk-free asset; leverage results in an expected return
more than the risk-free rate + risk premium, and a standard
deviation greater than that of the risky asset.
Risk Tolerance and Asset Allocation
For individual investors, the allocation decision depends
on the individual’s risk aversion, using the following
formula:
risky asset weighting = return premium
A * variance
A = risk aversion (larger number = higher aversion to risk)
Variance = SD^2
Asset Allocation Calculation
For an investor with a risk aversion factor of 4, what is
the preferred asset allocation of a portfolio with the
characteristics from slide 8:
Risk-free rate: 7%
Risk premium: 8%
Standard deviation of risky asset: 22%
Asset Allocation Calculation
For an investor with a risk aversion factor of 4, what is
the preferred asset allocation of a portfolio with the
previous characteristics:
Risky asset weighting = .08 / (4 * 0.22^2)
= 41.3%
Risk-free asset weighting = 1 – 41.3% = 58.7%
Asset Allocation Calculation
What is the implied risk aversion factor of the investor who
selected the asset allocation of 65% risky asset?
.65 = .08 / (A * 0.22^2)
.65 * (A * 0.22^2) = .08
A = (.08/.65) / 0.22^2
A = 2.54
Investment and
Portfolio Management
WEEK NINE
Reading
http://www.investopedia.com/articles/bonds/07/price_yield.asp
http://www.accountingcoach.com/bonds-payable/explanation/9
http://www.investopedia.com/calculator/bondprice.aspx
Bond Characteristics
Par value vs. market price
Par value = face amount of bond
Market price = value in secondary market
Coupon rate vs. yield
Coupon rate = interest rate based on face amount
Yield = bond return based on market price
Coupon payment =
face amount * coupon rate / # annual payments
Accrued Interest
Accrued interest calculation
Coupon payment
Days since last payment
x
Days in coupon period
Calculate accrued interest for the following bond:
Face amount
Coupon rate
Payment type
Days since last payment
Days in coupon period
$
5,000
6.24%
semiannual
42
182
Accrued Interest
Coupon payment:
$
5,000
Accrued interest:
$
156.00
x
x
6.24% =
2
42
182
=
$
156.00
$
36.00
Bond Pricing Overview
When a bond has attractive qualities (high coupon rate,
strong borrower) an investor pays a premium to (=more
than) the face amount of the bond.
When a bond has unattractive qualities (low coupon rate,
weak borrower) an investor pays a discount to (=less than)
the face amount of the bond.
When coupon rate > market rate, pricing is at a premium.
When coupon rate < market rate, pricing is at a discount.
Bond Pricing Formula
Bond value = PV of coupons + PV of par value
PV of coupons = Coupon * (1/r) * (1- [1/(1+r)n])
PV of par value = Par value/[(1+r)n]
R = periodic market rate
N = total number of payments
Bond Pricing Example
Face amount
Coupon rate
Payment type
Maturity (years)
Market rate
Preliminary calculations
Coupon payment:
Periodic market rate:
Number or coupons:
$
5,000
6.24%
semiannual
8
6.92%
$
156.00
3.46%
16
Bond Pricing
PV of coupons = $156 * (1/.0346) * (1- [1/(1+.0346)16])
= $1,892
PV of par value = $5,000/[(1+.0346)16]
= $2,901
$1,892 + $2,901 = $4,793
Bond Pricing
Is this a reasonable answer?
Market value < face amount; why? Let’s compare the
interest rates….
Coupon rate < market rate; thus, pricing should be at a
discount, and that is what we see in this example.
Inversely, when coupon rate > market rate, our bond
price calculation should reflect a premium.
Bond Pricing
Recalculate the bond price using a market rate of
5.92%.
Before calculating, note the new relationship between
coupon rate and market rate; which is greater? Based
on this relationship, do you expect to calculate a
premium price or a discount price?
Bond Pricing
PV of coupons = $156 * (1/.0296) * (1- [1/(1+.0296)16])
= $1,966
PV of par value = $5,000/[(1+.0296)16]
= $1,966 + $3,135
$1,966 + $3,135 = $5,101
Bond Pricing
In either of these calculations, we would add any accrued
interest to the bond price because the selling investor has
earned this portion of interest, and as the new owner we will
receive the full interest payment. If we purchased this bond
(in either the discount or the premium scenario) 20 days after
the last interest payment, we would pay accrued interest of:
$
156.00
x
20
182
=
$
17.14
Bond Yields
Yield to maturity = total yield over life of bond
Current yield = annual coupon / bond price
What is the current yield of the bond in the original
example?
$312 / $4,793 = 6.51%
Bond Yield Analysis
Note the comparison of yields:
Yield to maturity:
Current yield:
6.92%
6.51%
The yield to maturity reflects the additional benefit
of receiving the full face amount of the discounted
bond at maturity (pay $4,793, receive $5,000),
whereas the current yield only reflects interest
income for one year.
Default Risk and Bond Pricing
Bond prices change based on changes in interest rates
and company performance; the closer to maturity date,
the closer the bond price to face amount.
Bond safety is reflect in a credit rating, based on the
following factors:
Debt service coverage ratio
Debt to equity ratio
Current ratio
Profitability ratios (return on assets, return on equity)
Investment and
Portfolio Management
WEEK TEN
Readings
https://www.macabacus.com/valuation/comparable-companies
http://www.investopedia.com/articles/fundamental/04/041404.
asp
http://stocks.about.com/od/evaluatingstocks/a/pe.htm
http://stocks.about.com/od/evaluatingstocks/a/peg.htm
Equity Valuation Models
Dividend discount model
Comparable companies analysis
Price/earnings ratio
Discounted cash flow valuation (corporate finance)
Dividend Discount Model
The DDM calculates stock price based on the estimated
return on investment, the future dividend, and the
dividend growth rate:
stock price = dividend in 1 year / (return – growth)
Dividend Discount Model
Calculate the stock price of a company with the following
characteristics:
Dividends in one year:
Dividend growth rate:
Discount rate:
$2.18
4%
11.5%
2.18 / (.115-.04) = $29.07
Dividend Discount Model
What is the same company anticipates no dividend
growth?
Dividends in one year:
Dividend growth rate:
Discount rate:
$2.18
0%
11.5%
2.18 / (.115-0) = $18.96
Comparable Companies Analysis
Comparable companies analysis is the use of ratios for
a set of comparable companies to value a target
company.
The most commonly used comparable company ratios
are:
Enterprise value/EBITDA
Price/earnings (P/E)
Comparable Companies Analysis
Enterprise value
EBITDA
EV/EBITDA
Price
Earnings per share
P/E
Comparable Companies
B
A
26,047
13,320 $
$
3,070
1,780 $
$
8.5
7.5
$
$
12.42 $
0.72 $
17.3
29.87
2.04
14.7
Average
$
8.0
Target
???
5,905
8.0
???
$
16.0
1.49
16.0
Comparable Companies Analysis
Now that I know the average multiples for my
comparable companies (or “comps”), I can calculate
the value of my company.
Comparable Companies Analysis
EBITDA
EV/EBITDA
Enterprise value
Less net debt (debt - cash)
Equity value
Shares oustanding
Stock price
$
Earnings per share
P/E
Stock price
$
Stock price range: $23.78 to $26.33
$
$
$
$
$
5,905
8.0
47,144
14,500
32,644
1,240
26.33
1.49
16.0
23.78
Enterprise Value/EBITDA vs. Price/Earnings
Enterprise value is a measure of the entire balance
sheet (debt + equity) whereas price is a measure of
equity value only.
EBITDA is a measure of performance at the enterprise
level, regardless of capital structure, whereas earnings
is a measure of performance at the equity level after
interest has been paid to debt holders.
Price/Earnings Ratio
The P/E ratio represents the relationship between
stock price and earnings.
P/E ratio = Stock price / EPS (earnings per share)
EPS is usually calculated using 1 year future earnings.
Characteristics:
High growth: higher PE vs. comparable companies
High risk: lower PE vs. comparable companies
Price/Earnings Ratio
Calculate stock price based on the following data:
EPS:
P/E multiple:
$2.45 (= 1 year forecast of EPS)
14.6 (from comparable companies analysis)
14.6 = price / $2.45
price = 14.6 * $2.45 = $35.77
P/E Ratio and Earnings Growth
Stock price
EPS in 1 year
PE ratio
EPS in 3 years
PE ratio
Companies
A
B
$22.35
$41.20
$0.90
$3.12
24.8
13.2
$1.71
13.1
$3.90
10.6
Difference
46.8%
19.2%
What is happening? Due to the higher long term growth rate of
company A, over time the PE ratios converge (get closer). The stock is
“expensive” if we only look at the 1 year EPS, but looking farther into
the future, we see the basis for the stock price: future growth.
Discounted Cash Flow Valuation
DCF valuation uses financial modeling to forecast
future cash flows during the investment period and a
future enterprise value as the basis for a sale price,
and discounts these amounts to the present time.
We will develop this concept in the Corporate Finance
class.
How Do We Use Valuation?
We can use valuation to set the stock price for an IPO.
We can use valuation to evaluate an investment.
If our value > stock price: buy
If our value < stock price: sell
Investment and
Portfolio Management
WEEK TWELVE
Readings
http://www.accountingtools.com/financial-statement-analysis
http://www.investopedia.com/articles/fundamentalanalysis/08/dupont-analysis.asp
Financial Statement Analysis
Financial statement analysis is the calculation,
comparison, and evaluation of financial ratios.
Calculation: five categories of ratios
Comparison: with prior years and with comparable
companies
Evaluation: favorable or unfavorable financial
position/financial performance
Leverage Ratios
Interest coverage = EBIT / interest expense
Leverage = Assets / equity
Note: “leverage” can be defined in multiple ways.
The other common leverage calculation = debt/equity.
Assets/equity is always higher than debt/equity.
Asset Utilization Ratios
Asset turnover = sales / average assets
Inventory turnover = COGS / average inventory
Days receivables = average AR / sales * 365
NOTE: “average” = (beginning + ending) / 2
Liquidity Ratios
Current ratio = current assets / current liabilities
Quick ratio = (cash + securities + AR) / current liabilities
Profitability Ratios
ROA = EBIT / average assets
ROE = net income / average equity
Gross margin = Gross profit / sales
Operating margin = EBIT / sales
Profit margin = net income / sales
Note: EBIT = operating income
Market Price Ratios
P/E ratio = stock price / EPS
We covered the analysis of the P/E ratio in
comparable companies analysis.
Ratio Analysis: Comparison
Ratios
Leverage
Interest coverage
Leverage
Asset utilization
Asset turnover
Inventory turnover
Days receivables
Liquidity ratios
Current ratio
Quick ratio
2013
2014
2015
2016
2017
2.1
4.6
2.2
4.3
2.2
4.1
2.3
3.8
2.3
3.6
1.1
7.2
71.6
1.1
7.2
71.6
1.1
7.2
71.6
1.1
7.2
71.6
1.1
7.2
71.6
1.4
1.7
1.5
1.8
1.5
1.9
1.6
2.0
1.6
2.0
Ratio Analysis: Comparison
Profitability ratios
ROA
ROE
Gross margin
Operating margin
Profit margin
2013
2014
2015
2016
2017
6.3%
11.9%
17.6%
5.6%
2.2%
6.2%
11.2%
17.6%
5.6%
2.3%
6.2%
10.7%
17.6%
5.6%
2.3%
6.2%
10.2%
17.6%
5.6%
2.3%
6.1%
9.8%
17.6%
5.6%
2.4%
Ratio Analysis: Interpretation/Evaluation
Interpreting ratios is part science, part art.
Science: leverage of 50 is bad!
Art: leverage of 1.5… is this good or bad?
With less leverage (1.2 for example), I have less financial risk… but I
might miss out on the opportunity to increase my returns.
With more leverage (2.0, for example), I can increase my return on
equity… if I realize strong operating performance.
The following two slides provide guidelines to give you a
general idea of how to interpret ratio calculations; note
that results vary significantly from one industry to another.
Ratio Analysis: Ratio Ranges
Ratios
Leverage
Interest coverage
Leverage (= assets/equity)
Favorable Range
Low
High
Which is
Better?
2.0
1.0
6.0
2.0
High
Low
Asset utilization
Asset turnover
Inventory turnover
Days receivables
1.0
3.0
20
3.0
6.0
60
High
High
low
Liquidity ratios
Current ratio
Quick ratio
1.0
1.0
3.0
3.0
High
High
Ratio Analysis: Ratio Ranges
Favorable Range
Low
High
Profitability ratios
ROA
ROE
Gross margin
Operating margin
Profit margin
3.0%
5.0%
15.0%
10.0%
2.0%
10.0%
20.0%
60.0%
25.0%
10.0%
Which is
Better?
High
High
High
High
High