## Understanding Current Ratio

Current Ratio simply tells you how much liquidity a firm has –in other words, how much cash it could raise if it absolutely had to pay off its liabilities all at once.

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## Current Ratio

The current ratio simply tells you how much liquidity a firm has – in other words, how much cash it could raise if it absolutely had to pay off its liabilities all at once. A low ratio means the company may not be able to source enough cash to meet near-term liabilities, which would force it to seek outside financing or to divert operating income to pay off those liabilities.

### Current Ratio Formula

Current Ratio = Current Assets/Current Liabilities

### Calculating Current Ratio

Current Ratio is simply calculated by dividing Current Assets divided by Current Liabilities. Both Current Assets and Current Laibilities can be found in the Balance Sheet filed in the firm’s Annual Reports. Annual Reports can usually be found at the firm’s website or from SEBI EDIFAR database. Current Assets are those likely to be used up or converted into cash within one business cycle, usually defined as one year. Liabilities, similarly are those that have to be paid within a period of one year.

### Rough benchmarks for evaluating a stock’s Current Ratio

As a very general rule, a current ratio of 1.5 or more means the firm should be able to meet operating needs without much trouble. However when you find a company with current ratios of 3 or 4, you may want to be concerned. A number this high might also mean that management has so much cash on hand, they may be doing a poor job of investing it. It is always useful to compare companies within the same industry therefore, to get a better picture.

Unfortunately, some current assets – such as Inventories – may be worth less than their value on the Balance Sheet. (Imagine trying to sell old PCs or last year’s fashions to generate cash – you would be unlikely to receive anything close to what you paid for them).

If you see ratios around or below 1, should only be for companies those have inventories that can immediately be converted into cash (e.g. McDonalds). If this is not the case and a company’s number is low, that would be cause for concern.

Because of the general illiquid nature of inventories, there’s an even more conservative test of a company’s liquidity, the Quick Ratio

You may also like to learn more on other financial strength measures, as below.

## Understanding Debt to Equity ratio

Debt to Equity ratio is just what it sounds like – long-term debt divided by Shareholders’ equity.

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## Debt to Equity ratio

Debt to Equity ratio is just what it sounds like – long-term debt divided by Shareholders’ Equity. It’s a little like the financial leverage ratio, except that it is more narrowly focused on how much long-term debt the firm has per Rupee of Equity.

### Debt to Equity Formula

Debt to Equity = Long-Term Debt/Shareholders’ Equity

A high debt equity ratio for a firm indicates it has been aggressively financing its growth with debt. Due to the the additional interest expenses that have to be borne by the firm, this can result in volatile earnings.

A firm could potentially generate more earnings If a lot of debt is used to finance increased operations (high debt to equity) than it would have if it did not have access to this external financing. Shareholders would benefit if this resulted in increased earnings by an amount greater than the debt cost (interest). However, the cost of this debt financing may become too much for the company to handle, especially if earnings are cyclical and volatile, and outweigh the return that the company generates on the debt.

The debt equity ratio also varies depending on the industry in which a firm operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt equity ratio above 2, while software companies usually have a debt equity ratio of under 0.5.

### Calculating Debt to Equity

Debt to Equity is simply calculated by dividing Total Debt (long-term debt is usually not reported separately in Annual Reports of Indian companies) divided by Shareholders’ Equity. Both Total Debt  (sum up secured and unsecured loans) and Shareholders Equity can be found in the Balance Sheet filed in the firm’s Annual Reports. Annual Reports can usually be found at the firm’s website or from SEBI EDIFAR database. Shareholders Equity is simply the difference between Total Assets and Total Liabilities – the assets that the business has generated.

### Rough benchmarks for analysing a stock’s Debt to Equity

The lower the better. Companies with Debt to equity less than 1 are conservatively financed.

You may also like to learn more on other financial strength measures, as below.

## Understanding Financial Leverage

Financial Leverage is essentially a measure of how much debt a company carries, relative to shareholders’ equity

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## Financial Leverage

A common measure of leverage is simply the Financial Leverage ratio.

### Financial Leverage Formula

Financial Leverage = Assets /Shareholders’ Equity

Think of it like a Mortgage – a homebuyer who puts Rs. 200,000 down on a Rs. 1,000,000 house has a financial leverage ratio of 5. For every Rupee in Equity, the buyer has Rs. 5 in assets.

The same holds true for companies. In 2008, a retailer like Trent has a financial leverage ratio of 2.1, meaning that for every Rupee in equity, the firm has Rs. 2.1 in total assets. (It borrowed the other Rs. 1.1.)

Financial Leverage is something you need to watch carefully. As with any kind of debt, a judicious amount can boost returns, but too much can lead to disaster. Look at the kind of business a firm is in. If it’s fairly steady, a company can probably take on large amounts of debt without too much risk because there’s only a small chance of the business falling off a cliff and the company being caught short when bondholders demand their interest payments. On the flip side, be very wary of a high finacial leverage ratio if a company’s business is cyclical or volatile. Because interest payments are fixed, the company has to pay them whether business is good or bad.

### Calculating Financial Leverage

Return on Equity is simply calculated by dividing Total Assets by Shareholders’ Equity. Both Total Assets and Shareholders Equity can be found in the Balance Sheet filed in the firm’s Annual Reports. Annual Reports can usually be found at the firm’s website or from SEBI EDIFAR database. Shareholders Equity is simply the difference between Total Assets and Total Liabilities – the assets that the business has generated. Shareholder equity is an accounting term that represents the assets created by the retained earnings of the business and the paid-in capital of the owners. Total Assets is simply all the property owned by a company. Total assets include current assets; fixed assets such as buildings, plant and machinery, and other assets such as licenses and goodwill.

### Rough benchmarks for analysing a firm’s Financial Leverage

A financial leverage ratio of 2.1 is fairly conservative, even for a fast growing retailer. Its when we see ratios of 4, 5 or more that companies start to get really risky.

However, financial firms and banks have a much larger asset base relative to equity. The average bank has a financial leverage ratio in the range of 12 to 1 or so, as compared to 2-to-1 or 3-to-1 for the average company.

You may also like to learn more on other financial strength measures, as below.

## Intrinsic Value -Stock Valuation basics

Learn how we can go about calculating Intrinsic Value – or what a stock is really worth! Without knowing what a stock is worth, how can you know how much you should pay for it?

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## Intrinsic Value – What a stock is worth?

Without knowing what a stock is worth- in other words its Intrinsic Value- how can you know how much you should pay for it? Stocks should be purchased because they are trading at some discount to their intrinsic value, not simply because they are priced at a higher or lower point than similar companies.

The big drawback of the ratios discussed in the Stock Valuation framework is that they are all based on price – they compare what investors are currently paying for one stock to what they are paying for another stock. Ratios do not, however, tell you anything about value, which is what a stock is actually worth. Comparing ratios across companies and across time can help us understand whether our valuation estimate is close to or far from the mark, but estimating the intrinsic value of a company gives us a better target.

Pat Dorsey, Director of Stock Analysis, Morningstar Inc. in his very useful book – The 5 Rules for Successful Stock Investing – tells us how we can go about calculating what a stock is really worth- in other words, its Intrinsic Value. His writings are the primary source for this article.

Having an intrinsic value estimate keeps you focused on the value of the business, rather than a piece of the stock – and that’s what you want because, as an investor, you are buying a small piece of a business. Intrinsic valuation also forces you to think about the cash flows that a business is generating today and the cash it could generate in the future, as well as the returns on the capital that the firm creates. It makes you ask yourself, “If I could buy the whole company, what would I pay?

Second, having an intrinsic value gives you a stronger basis for making investment decisions. Without looking at the true determinants of value, such as cash flow and return on capital, we have no way of assessing whether a P/E of, for example 15 or 20 is too low, too high, or right on target. After all, the company with the P/E of 20 might have much lower capital needs and a less risky business than the company with the P/E of 15, in which case it might actually be the better investment.

### Cash Flow, Present Value, and Discount Rates

What is a stock worth? Economists Irving Fisher and John Burr Williams answered this question for us more than 60 years ago. The value of a stock is equal to the present value of its future cash flows. No more and no less.

Companies create economic value by investing capital and generating a return. Some of that return pays operating expenses, some get re-invested in the business, and the rest is free cash flow. Remember we care about the free cash flow because that’s the amount of money that could be taken out of the business each year without harming its operations. A firm could use free cash flow to benefit shareholders in a number of ways. It can pay a dividend, which essentially converts a portion of each investor’s interest in the firm to cash. It can buy back stock, which reduces the number of shares outstanding and thus increases the percentage ownership of each shareholder. Or, the firm can retain the free cash flow and re-invest it in the business.

These free cash flows are what give the firm its investment value. A present value calculation simply adjusts those future cash flows to reflect the fact that money we plan to receive in the future is worth less than money we receive today.

Why are future cash flows worth less than the current ones? First, money that we receive today can be invested to generate some kind of return, whereas we cant invest future cash flows until we receive them. This is the time value of money. Second, there is a chance that we may never receive those future cash flows, and we need to be compensated for that risk, called the risk premium.

The time value of money is essentially the opportunity cost of receiving money in the future versus receiving it today, and is often represented by the interest rates being paid on government bonds. Its pretty certain that the government will be around to pay us our interest in a few years.

Of course, not many cash flows are as certain as those from the government, so we need to take an additional premium to compensate us for the risk that we may never receive the money we have been promised. Add the government bond rate to the risk premium, and we have what’s known as a discount rate.

Now you can start to see why stocks with stable, predictable earnings often have such high valuations – investors discount their future cash flows at a lower rate, because they believe that there’s a lower risk attached to the likelihood that those future cash flows will actually show up. Conversely a business with an extremely uncertain future should logically have a lower valuation because there is a substantial risk that the potential future cash flows will never materialise.

You can see why a rational investor should be willing to pay more for a company that’s profitable now relative to one that promises profitability only at some point in the future. Not only does the latter carry a higher risk (and thus a higher discount rate), but the promised cash flows won’t arrive until some years in the future, diminishing their value still further.

Changing discount rates and the timing of cash flows can have a telling effect on present value. In all three examples, below -StableCorp, CycliCorp, and RiskCorp -the sum of the undiscounted cash flows is about \$32000.

However, the value of the discounted cash flows is quite different from company to company. In present value terms, CycliCorp is worth about \$2700 less than StableCorp. That’s because StableCorp is more predictable, which means that investors’ discount rate isn’t high. CycliCorp’s cash flow increases by 20 percent some years and shrinks in some years, so investors perceive it as a riskier investment and use a higher discount rate when they are valuing its shares. As a result the present value of the discounted cash flows is lower.

The difference in the present value of the cash flows is even more acute when you look at RiskCorp, which is worth almost \$8300 less than StableCorp. Not only are the bulk of RiskCorp’s cash flows far off in the future, bu also, we are less certain that they will come to pass, so we assign an even higher discount rate.

This is the basic principle behind a discounted cash flow model. Value is determined by the amount, timing, and riskiness of a firm’s future cash flows, and these are the three items you should always be thinking about when deciding how much to pay for a stock. That’s all it really boils down to.

### Calculating Present Value

To find the present value of a \$100 future cash flow, divide that future cash flow by 1.0 plus the discount rate. Using a 10% discount rate, for example, a cash flow of \$100 one year in teh future is worth \$100/1.10. or \$90.91. A \$100 cash flow two years in the future is worth \$100/(1.10×1.10), or \$82.64. In other words, \$82.64 invested at 10% becomes \$90.91 in a year and \$100 in 2 years. Discount rates are really just interest rates that go backwards through time instead of forwards.

Generalising the previous formula, if we represent the discount rate as R, the present value of a future cash flow (CF) in year N equals

### Fun with discount rates

Now that we have the formula down, we need to figure out what factors determine discount rates for use in Intrinsic Value calculations. How do we know whether to use 7 percent or 10 percent?

Unfortunately, there is no precise way to calculate the exact discount rate that you should use in discounted cash flow (DCF) model, and academicians have filled entire journals with nothing but discussions on the right way to estimate discount rates for Intrinsic value calculations.

Here’s what you want to know for practical purposes. As interest rates rise, so will discount rates. As a firm’s risk level increases, so will its discount rate. Let’s put these two together. For interest rates you can use the long-term average of treasury rates as a reasonable proxy. (Remember we use interest rate on treasuries to represent opportunity costs because we are pretty certain that the government will pay us our promised interest).

Now for risk, which is an even less exact factor to measure. Here are some factors that should be taken into account when estimating discount rates.

Size

Smaller firms are generally riskier than larger firms because they’re more vulnerable to adverse events. They also usually have less diversified product lines and customer bases.

Financial Leverage

Firms with more debt are generally riskier than firms with less debt because they have a higher proportion of fixed expenses (debt payments) relative to other expenses. Earnings will be better in good times, but worse in bad times, with an increased risk of financial distress. Look at a firm’s debt-to-equity ration, interest coverage, and a few other factors to determine the degree of a company’s risk from financial leverage.

Cyclicality

Is the firm in a cyclical industry (such as commodities or automobiles) or a stable industry (such as breakfast cereal or beer)? Because the cash flows of cyclical firms are much tougher to forecast than stable firms, their level of risk increases.

Management/Corporate Governance

This factor boils down to a simple question: How much do you trust the folks running the shop? Although its rarely black or white, firms with promotional managers (who leave no opportunity to drum up stock prices through their media appearances), managers who draw egregious salaries, or who exhibit any of the other red flags are definitely riskier than companies with managers who do not display these traits.

Economic Moat

Does the firm have a wide moat, a narrow moat, or no economic moat? The stronger a firm’s competitive advantage -that is, the wider its moat- the more likely it will be able to keep competitors at bay and generate a reliable stream of cash flows.

Complexity

The essence of risk is uncertainty. And its tough to value what you can’t see. Firms with extremely complex businesses or financial structures are riskier than simple, easy-to-understand firms because there’s a greater chance that something unpleasant is hiding in a footnote that you missed. Even if you think management is as honest as the day is long and that the firm does a great job running its operations, its wise to incorporate a complexity discount into your mental assessment of risk.

How should you incorporate all of these risk factors into a discount rate? There is no right answer.

Morningstar uses 10.5 percent as the discount rate for an average company based on the above factors and creates a distribution of discount rates based on whether firms are riskier or less risky than the average. A so mid-2003, firms such as Johnson and Johnson, Colgate and Wal-Mart fall at the bottom of the range at around 9 percent, whereas riskier firms such as Micron technology, JetBlue Airways, and E*Trade -top out at 13 percent to 15 percent.

The key is to pick a discount rate you are comfortable with. Don’t worry about being exact -just think about whether the company you are evaluating is riskier or less risky than the average firm, along with how much riskier or less risky it is, and you will be fine.

Discount rates for the Indian market context

In the Indian market context we may use 15% as the discount rate for an average company (8 percent risk-free rate + 7 percent risk-premium). High-Quality companies may be discounted at a low rate of 12%, above-average companies at 13%, and poor quality companies may be discounted at a high of 18%.

### Calculating Perpetuity Values

We have cash flow estimates, and we have a discount rate. We need one more element called a perpetuity value. We need a perpetuity because it’s not feasible to project a company’s future cash flows out to infinity, year-by-year, and because companies have theoritically finite lives.

The most common way to calculate a perpetuity is to take the last cash flow (CF) that you estimate, increase it by the rate at which you expect it to grow over the very long term (g), and divide the result by the discount rate (R) minus the expected long-term growth rate.

The result of this calculation than must be discounted back to present, using the method discussed for calculating present value. For example, suppose we are using a 10-year DCF model for a company with an 11 percent discount rate. We estimate that the company’s cash flow in year 10 will be \$1 billion and its cash flow will grow at a steady 3 percent annual rate after that. (Three percent is generally a good number to use as your long-run growth rate because it’s roughly the U.S. gross domestic product [GDP] growth. If you are valuing a firm in a declining industry, you might use 2 percent).

Perpetuity Value = \$ 1 billion x (1+ 0.03) / (0.11-0.03)

= \$ 1.03 billion/ 0.08

= \$ 12.88 billion

To get the present value of these cash flows, we need to discount them using the formula

where n is the number of years in the future, CFn is the cash flow in year n, and R is the discount rate. Plugging these numbers, N = 10, CFn = \$12.88 billion, R= 0.11

Discounted Perpetuity Value = \$12.88 bn/ (1+0.11)^10 = \$12.88 bn/2.839 = \$4.536 bn

### Calculating Intrinsic Value

Now all that we need to do is add this discounted perpetuity value to the discounted value of our estimated cash flows in years 1 through 10, and divide by the number of shares outstanding.

That was a brief outline of the process. You can follow along by matching the following steps:1. Estimate free cash flows for the next 4 quarters. This amount will depend on all of the factors discussed earlier -how fast the company is growing, the strength of its competitors, its capital needs, and so on. Using Clorox as an example, our first step is to see how fast free cash flow has grown over the past decade, which turns out to be 9% when we do the math. We could just increase the \$600 million in free cash flow that Clorox generated in 2003 by 9 percent, but that would assume the future would be as rosy as in the past. Mega retailers like Wal-Mart -which now accounts for almost a quarter of Clorox sales -has hurt the bargaining power of consumer-product firms. So, let’s be conservative and assume free cash flow increases by only 5 percent over the last year, which would work out to \$630 million.

2. Estimate how fast you think free cash flow will grow over the next 5 to 10 years. Remember, only firms with very strong competitive advantages and low capital needs are able to sustain above-average growth rates for very long. If the firm is cyclical don’t forget to throw in some bad years. We won’t do this for Clorox because selling bleach and Glad bags is a very stable business. We will however be conservative on our growth rate because of the “Wal-Mart factor”, and will assume free cash flow increases at 5 percent annually over the next decade.

3. Estimate a discount rate. Financially Clorox is rock-solid, with little debt, tons of free cash flow, and a non-cyclical business. So we will use 9% for our discount rate, which is meaningfully lower than the 10.5 percent average we discussed earlier. Clorox, is a predictable company, after all.

4. Estimate a long-run growth rate. Because people will still need bleach and trash bags in the future, and its a good bet that Clorox will continue to get a piece of that market, we can use the long-run GDP average of 3 percent.

5. That’s it! We discount the first 10 years of cash flows, add that value to the present value of the perpetuity, and divide by the shares outstanding.

This is a very simple DCF model. The one used at Morningstar has about a dozen excel tabs, adjusts for complicated items such as pensions and operating leases, and explicitly models competitive advantage periods, among many other things. But a model doesn’t need to be super complex to get you most of the way there and help you clarify your thinking.

The important thing is that we forced ourselves to think through these kinds of issues as discussed earlier, which we wouldn’t have if we had just looked at Clorox’s stock chart or if we had just said, “Sixteen times earnings seem reasonable”. By thinking about the business, we arrived at a better valuation in which we have more confidence.

Valuing Clorox using a Discounted Cash Flow model

## Margin of Safety

We have analysed a company, we have valued it – now we need to know when to buy it. If you really want to succeed as an investor, you should seek to buy companies at a discount to your estimate of their intrinsic value. Any valuation and any analysis is subject to error, and we can minimise the effect of these errors by buying stocks only at a significant discount to our estimated intrinsic value. This discount is called the Margin of Safety, a term first popularised by investing great Benjamin Graham.

Here is how it works. Let’s say we think Clorox’s intrinsic value is \$54, and the stock is trading at \$45. If we buy the stock and we’re exactly right about our analysis, the return we receive should be the difference between \$45 and \$54 (20 percent) plus the discount rate of about 9 percent. That would be 29 percent, which is a pretty darn good return, all things considered.

But what if we are wrong? What if Clorox grows even more slowly than we had anticipated -may be a competitor takes market share – or the firm’s pricing power erodes faster than we had thought? If that’s the case, then Clorox’s intrinsic value might actually be \$40, which means we would have overpaid for the stock by buying it at \$45.

Having a margin of safety is like an insurance policy that helps prevent us from overpaying – it mitigates the damage caused by overoptimistic estimates. If, for example, we had required a margin of safety of 20 percent before buying Clorox, we wouldn’t have purchased the stock until it fell to \$43. In that case, even if our initial analysis had been wrong and the fair value had really been \$40, the damage to our portfolio wouldn’t have been as severe.

Because all stocks aren’t created equal, not all margins of safety should be the same. It’s much easier to forecast the cash flows of, for example, Anheuser-Busch over the next 5 years than the cash flows of Boeing. One company has tons of pricing power, dominant market share, and relatively stable demand, whereas the other has relatively little pricing power, equal market share, and highly cyclical demand. Because I am less confident about my forecasts for Boeing, I’ll want a larger margin of safety before I buy the shares. There’s simply a greater chance that something might go wrong, and that my forecasts will be too optimistic.

Paying more for better businesses makes sense, within reason. The price you pay for a stock should be closely tied to the quality of the company, and great businesses are worth buying at smaller discounts to intrinsic value. Why? Because high-quality businesses – those that have wide economic moats – are more likely to increase in value over time, and it’s better to pay fair price for a great business than a great price for a fair business.

How large should your margin of safety be? It ranges all the way from just 20 percent for very stable firms with wide economic moats to 60 percent for high-risk stocks with no competitive advantages. For above-average firms we would require a 25 percent margin of safety, while on average, we require a 30 percent to 40 percent margin of safety for most firms.

Having a margin of safety is critical to being a disciplined investor because it acknowledges that as humans, we are flawed. Simply investing in the stock market requires some degree of optimism about the future, which is one of the biggest reasons that buyers of stocks are too optimistic far more often than they’re too pessimistic. Once we know this, we can correct for it by requiring a margin of safety for all of our share purchases.

Every approach to equity investing has its own warts. Being disciplined about valuation may mean that you will miss out on some great opportunities because some companies wind up performing better for longer periods of time than almost anyone could have anticipated. Companies such as Microsoft looked very pricey back in their heyday, and its unlikely that many investors who were very strict about valuation would have bought it early in their corporate lives.

Being disciplined about valuation would have meant missing those opportunities, but it also would have kept you out of many investments that were priced like Microsoft, but which wound up disappointing investors in a big way. Although we acknowledge that some high-potential companies are worth a leap of faith and a high valuation, on balance, we think its better to miss a solid investment because you are too cautious in your initial valuation than it is to buy stocks at prices that turn out to be too high.

After all, the real cost of losing money is much worse than the opportunity cost of missing out on gains. that’s why the price you pay is just as important as the company you buy.

## Understanding Free cash flow (FCF)

Free Cash Flow enables us to separate out businesses that are net users of Capital – ones that spend more than they take in- from businesses that are net producers of Capital

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## Free Cash Flow

Free cash flow (FCF) is calculated by subtracting Capital expenditures from Operating cash flow. Cash Flow from Operations measures how much cash a company generates. It is the true touchstone of corporate value creation because it shows how much cash a company is generating from year to year. As useful as the Cash Flow statement is, it does not take into account the money that a firm has to spend on maintaining and expanding its business. To do this, we need to subtract Capital Expenditures, which is money used to buy fixed assets.

### Free Cash Flow Formula

Free Cash Flow = Cash Flow from Operations – Capital Expenditure

Free Cash Flow enables us to separate out businesses that are net users of Capital – ones that spend more than they take in- from businesses that are net producers of Capital, because its only that excess cash that really belongs to shareholders. Free Cash Flow is sometimes referred to as “Owners Earnings” because that’s exactly what it is: the amount of money the owner of a company could withdraw from the treasury without harming the company’s ongoing business.

A firm that generates a great deal of FCF can do all sorts of things with the money – save it for future investment opportunities, use it for acquisitions, buy back shares, and so forth. Positive FCF gives financial flexibility because the firm isn’t relying on the capital markets to fund its expansion. Firms that have negative FCF have to take out loans or sell additional shares to keep things going, and can thus become a risky proposition if the market becomes unsettled at a critical time for for the company.

There is a view that most analysts myopically focus on earnings while ignoring the real cash that a firm generates. While earnings can often be clouded by accounting tricks, it’s much tougher to fake cash flow. For this reason, seasoned investors believe that FCF gives a much clearer view of the ability to generate cash (and thus profits).

### Rough benchmarks for analysing a firm’s Free Cash Flow

As with ROE it’s tough to generalise how much FCF is enough. However its reasonable to say that any firm that is able to convert more than 10% of Sales to FCF (just divide FCF by Sales to get this percentage) is doing a solid job at generating excess Cash.

### Using Free Cash Flow ratio while analysing stocks

I tend to think positive FCF companies will always have low levels of business risk than those with negative FCF. It’s also extremely useful to draw a direct correlation between FCF and RoE.

I like to see companies with high FCF coupled with high RoEs, this is the sweet spot – excess cash and the ability to earn a high return on it. Companies with these characteristics tend to be the cream of the crop and have a low level of business risk. Usually these type of stocks form the Core of my holdings, as opposed to my Long Shots (search for multibaggers). Infosys (also TCS), Balmer Lawrie, Sun Pharmaceuticals, HDFC, Sesa Goa are good examples in the Indian stock market.

Negative FCF is not necessarily a bad thing. Because, you can always find companies that are re-investing all of their cash in business expansion but are still able to generate a high RoE. These firms have profitable reinvestment opportunities, and they should be spending all the cash they generate on expansion. These expansion efforts may pay off in the form of fat profits in the future. A good example in India Stock market is Bharti Airtel.

Apart from identifying the “cream” to form the Core of my portfolio, and separating excellent businesses from the rest, I have learnt not to give too much importance to FCF while stockpicking – especially multibagger prospects, except to check that the trend is improving. For these kind of companies in their early growth stages with nice RoE levels, I rather check that Operating Cash Flow should be positive and increasing. If Operating Cash Flow is negative and/or shows a declining trend over a number of years, that’s a red herring (warning sign) for me, leading me to pass up on them.

You may also like to learn more on valuation techniques that use cash flow measures, as below.

## Understanding Return on Invested Capital (ROIC)

Return on Invested Capital (ROIC) is overall a better measure of profitability. ROIC removes the debt related distortion that can make highly leveraged companies look very profitable when using ROE.

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## Return on Invested Capital (ROIC)

Return on Invested Capital (ROIC) is a sophisticated way of analysing a stock for return on Capital that adjusts for some peculiarities of ROA and ROE. Its worth knowing how to interpret it because its overall a better measure of profitability than ROA and ROE. Essentially ROIC improves on ROA and ROE because it puts debt and equity financing on an equal footing. It removes the debt related distortion that can make highly leveraged companies look very profitable when using ROE. It also uses a different definition of Profits than ROE and ROA, both of which use Net Profits. ROIC uses Operating Profits after taxes, but before interest expenses (PBIT)

Again, the goal is to remove any effects caused by a company’s financing decisions -does it use debt or equity?- so that we can focus as closely as possible on the profitability of the core business.

The true operating performance of a firm is best measured by ROIC, which measures the return on all capital invested in the firm regardless of the source of the capital. The formula for ROIC is deceptively simple

### Return on Invested Capital Formula

ROIC =Net Operating Profit after Taxes (NOPAT)/Invested Capital

Invested Capital =Total Assets – Non-Interest bearing Current Liabilities – Free Cash Flow

(Non-interest bearing current liabilities usually are Accounts Payable and other Current Assets)

You may also want to subtract Goodwill, if it’s a large percentage of Assets.

What does all this mean to you if you hear someone talking about ROIC? Simply that you should interpret ROIC just as you would ROA and ROE – a higher Return on Invested Capital is preferable to a lower one!

### Rough benchmarks for analysing a firm’s ROIC

In general, any non-financial firm that can generate consistent ROICs above 15 percent is atleast worth investigating. As of mid 2008, only about 10% of the non-financial firms listed in NSE were able to post an ROIC above 15% for each of the past 5 years, so you can see how tough it is to post this kind of performance. And if you can find a company with consistent ROICs over 30%, there’s a good chance you are really onto something.

Related content

## Understanding Return on Equity (ROE)

Return on equity measures how good a company is at earning a decent return on shareholders’ money. Think of it as measuring profits per dollar of shareholders’ capital.

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## Return on Equity (ROE)

Return on Equity (ROE) is a great overall measure of a company’s profitability because it measures the efficiency with which a company uses shareholders’ equity. Think of it as measuring profits per rupee of shareholders’ capital.

As a rule of thumb, firms that are consistently able to post ROEs above 20% are generating solid returns on shareholders’ money, which means they are likely to have economic moats. Significantly, Return on Equity can tell us more than just the efficiency of using shareholders capital. ROE provides a direct peek into how well a firm balances – profitability, asset turnover and financial leverage – to provide decent returns on shareholders’ equity.

This is because there are only three levers for boosting ROE – Net Margin, Asset Turnover and Financial Leverage. Let’s see why this is so by examining the return on equity formula.

### Return on Equity Formula

ROE = Earnings/Shareholders’ Equity

Alternatively expressed as ROE = (Earnings/Sales) x (Sales/Assets) x (Assets/Shareholders’ Equity), or

ROE = Net Margin x Asset Turnover x Financial Leverage

So we have three levers that can boost Return on equity -net margins, asset turnover, and financial leverage. For example, a firm can have only so-so margins and modest levels of financial leverage, but it could do a great job with asset turnover (e.g. a well run discount retailer). Companies with high asset turnover are extremely efficient at extracting more rupees of revenue for each rupee invested in hard assets. A firm might have asset turns only middling, and the firm might not have much leverage, but say it has great profit margins (e.g. a luxury goods company) – that would make for decent ROEs. Finally, a firm can also boost its ROE to respectable territory by taking on good-size amounts of leverage (e.g mature firms such as Utilities).

### Calculating Return on Equity

Return on Equity is simply calculated by dividing Profit after Tax (annual earnings) divided by Shareholders’ Equity. Profit after Tax can be taken from the Profit and Loss Statement from the firm’s Annual Reports. The Shareholders Equity can be found in the Balance Sheet filed in the firm’s Annual Reports. Annual Reports can usually be found at the firm’s website or from SEBI EDIFAR database. Shareholders Equity is simply the difference between Total Assets and Total Liabilities – the assets that the business has generated.

### Rough benchmarks for analysing a stock’s ROE

In general, any non-financial firm that can generate consistent ROEs above 15 percent without excessive leverage is atleast worth investigating. And if you can find a company with the potential for consistent ROEs over 30%, there’s a good chance you are really onto something.

### Two Caveats when using ROE to analyse stocks

First, Banks always have enormous financial leverage ratios, so don’t be scared off by a leverage ratio that looks high relative to a non-bank. Additionally, since banks’ leverage is always so high, you want to raise the bar for financial firms – look for consistent ROEs above 18% or so.

Second caveat is about firms with ROEs that look to good to be true, because they are usually just that. ROEs above 50% or so are often meaningless because they have probably been distorted by the firm’s financial structure. Firms that have been recently spun off from parent firms, companies that have bought back much of their shares, and companies that have taken massive charges often have very skewed ROEs because their Equity base is depressed. When you see an ROE over 50%, check to see if the company has any of these above-mentioned characteristics.

Related content

## Understanding Return on Assets (ROA)

Think of Return on Assets (ROA) as a measure of efficiency. Companies with high ROAs are better at sweating Assets for higher Profits.

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## Return on Assets (ROA)

ROA tells an investor how much Profit or Return a company generated for each Rupee of Assets.

### Formula for Return on Assets

ROA = Earnings/Assets Alternatively, this can also be expressed as ROA = (Earnings/Sales) x (Sales/Assets), or

ROA = Net Margin x Asset Turnover

The first component of Return on Assets is simply Net Margin, or Net Income divided by Sales. It tells us how much of each Rupee of Sales a company keeps as Earnings, after paying all the costs of doing business.

The second component is Asset Turnover, or Sales divided by Assets, which tells us roughly how efficient the firm is at generating Revenue for each Rupee of Assets.

Multiply these two, and we have the formula for Return on Assets.

### Utility Value of Return on Assets

ROA helps us understand that there are two routes to obtain excellent operational profitability. The company can charge high prices for its products (high margins) or it can turn over its assets quickly.

When using ROA as a comparative measure it is best to compare it against a firm’s previous ROA numbers or the ROA of a similar company. ROA for public companies can vary substantially and will be highly dependent on the industry.

### Calculating Return on Assets

Calculate ROA by simply dividing Profit after Tax (annual earnings) by Average of Total Assets. Calculate Average Total Assets for any fiscal period by adding Total Assets for the fiscal and the previous fiscal and divide by two. Profit after Tax can be taken from the Profit and Loss Statement from the firm’s Annual Reports. The firm’s Total Assets can be found in the Balance Sheet filed in the firm’s Annual Reports. Annual Reports can usually be found at the firm’s website or from SEBI EDIFAR database. Total Assets refers to all the resources a company has at its disposal – the shareholders capital plus short and long term borrowed funds.

### Rough benchmarks for analysing a firm’s ROA

All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned Rs. 20 for each Rs. 100 in assets. As a general rule, anything below 5% is very asset-heavy [manufacturing, railroads], anything above 20% is asset-light [advertising firms, software companies].