Return On Investment (ROI)

 Finance & Business

 Financial Measures

Return on Investment (ROI) is a traditional financial measure similar to Return on Equity (ROE)

that is used to measure corporation's profitability that reveals how much profit a company
generates with the money and other sources from investors.

Return on Investment is based on historic data.  It is a backward-looking metric that yields no

insights into how to improve business results in the future.

It is the ratio of money gained or lost on an investment relative to the amount of money invested.

How is the Return on Investment ROI ratio used?

It is used as a general indication of the company's efficiency; in other words, how much profit the
company is able to generate given the resources provided by its investors.

Investors usually look for companies with Returns on Investment that are high and growing.

Decision makers often look for ways to improve ROI by reducing costs, increasing gains, or
accelerating gains.

It is also a measure of how well a company used reinvested earnings to generate additional
earnings.

Return on Investment (ROI) in Investments

In case of stocks, Return on Investment (ROI) is the annual return you would expect to receive on
an investment.

ROI, when talking about stocks, is composed of two parts:

o income
o capital gains

In case of stocks, income is the dividend, which is usually paid each quarter. The income return,
known as the dividend yield, is simply the sum of dividends for the year divided by the stock
price.

The return from capital gains is the percentage gain in the stock price each year. These capital
gains have historically accounted for most of the ROI.

In the last half century, stocks have provided ROI of 13%. Dividend yields have averaged about
3% and capital gains have averaged about 10%.

Formula for the Return on Investment metric

                             Net Income 
Return on Investment = -----------------------
                         Book Value of Assets
What are the Return on Investment ROI values?
ROI is expressed as a percentage. The higher the ratio, the more efficient the company was in
utilizing invested capital.

S&P 500 companies exhibit ROI at around 8%.

Disadvantages of the Return on Investment ROI ratio?

Easily manipulated

The calculation of Return on Investment can be easily modified based on the analysis objective. It
depends on what we include in revenues and costs.

For example, we may calculate ROI as dividing the revenue that each product has generated by its
respective expenses, that would be from marketing perspective.

On the other hand, a financial analyst would more likely divide the net income of an investment
by the total value of all resources that have been employed to make and sell products.

As you can see, each person having different point of view would calculate ROI differently. The
ROI result can be expressed in many different ways, so when using this metric, it is important to
understand what inputs are being used.

ROI is sensitive to leverage

Assuming that proceeds from debt financing can be invested at a return greater than the
borrowing rate, ROI will increase with greater amounts of leverage.

Overstatement

The degree to which Return On Investment (ROI) overstates the underlying economic value
depends on several factors:

1. Depreciation: Depreciation rates faster than straight-line basis will result in a lower net
income and therefore also in a lower ROI.
2. Growth rate of new investment: Faster growing companies will have lower Return
On Investment because they need more equity.
3. Length of project life: The longer lifespan a project has, the more likely the ROI is going
to be overstated.
4. Capitalization policy: The smaller the fraction of total investment is capitalized in the
books, the greater will be the overstatement of ROI.
5. Lag between investment outlays and their recoupment: The longer it takes to recoup
profits, the greater the degree of overstatement.

Now let us take a look at another way to calculate ROI.

Alternative calculation
In some cases the Return on Investment (ROI) may be calculated using the following formula:

                         Net Income + Interest(1 - Tax Rate)

Return on Investment = --------------------------------------
                                  Book Value of Assets

Net Income is increased by interest after taxes. This measure is more accurate because companies
can have a lot of cash that earns interest.
Is there any other ratio related to this?
Yes, finance practicioners use other ratios when they analyze financial health of companies. For
example the following:

Return On Assets (ROA),

Return on Equity (ROE),

Free Cash Flow (FCF),

Quick Ratio (QuR),

Price Earnings Ratio (P/E Ratio),

or the Cash Asset Ratio (CAR).

Return On Assets (ROA)

 Finance & Business

 Financial Measures

Retun On Assets (or ROA for short) is an indicator informing the user abouthow profitable a
company is relative to its total assets. It tells the user how effective a business has been at
putting its assets to work.

In other words, the ROA is a test of capital utilization, that is how much profit (before interest and
income tax) a business earned on the total capital used to make that profit.

This ratio is most useful when compared with the interest rate paid on the company's debt. For
example, if the ROA is 25 percent and the interest rate paid on its debt was 15 percent, the
business's profit is 10 percentage points more than it paid in interest.

How is Retun on Assets ROA calculated

It is calculated by dividing a company's annual earnings by its total assets. ROA is usually noted
as a percentage.

Similar metric to Retun on Assets ROA

Where asset turnover informs an investor about the total sales for each $1 of assets, Return on
Assets tells an investor how much profit a company generated for each $1 in assets. ROA is
sometimes also referred to as Return on Investment.

When to use Retun on Assets ROA

Use this ratio to compare your business' performance to your industry's norms and standards.

The formula for Retun on Assets ROA

                    Earnings before Interest and Taxes (EBIT)
Return on Assets = -------------------------------------------
                             Net Operating Assets

Earnings before interest and taxes (EBIT) divided by net operating assets.

Is there any other ratio related to this?

Yes, finance practicioners use other ratios when they analyze financial health of companies. For
example the following:

Return On Equity (ROE),

Return on Investment (ROI),

Quick Ratio (QuR),

Capital Adequacy Ratio (CAR),

or the Cash Asset Ratio (CAR).

Return On Equity (ROE)

 Finance & Business

 Financial Measures

Return On Equity (ROE) is an accounting method similar to Return on Investment (ROI) that is

used as a measure of a corporation's profitability that reveals how much profit a company
generates with the money raised from shareholders.

It is also a measure of how well a company used reinvested earnings to generate

additional earnings, equal to a fiscal year's after-tax income (after preferred stock dividends but
before common stock dividends).

How is the Return On Equity (ROE) ratio used?

It is used as a general indication of the company's efficiency; in other words, how much profit the
company is able to generate given the resources provided by its stockholders.

Investors usually look for companies with returns on equity that are high and growing.

What is the formula for calculating the Return On Equity (ROE)

ratio?
                               Net Income
Return on Equity = -------------------------------------
                     Book Value of Shareholders' Equity

Return On Equity (ROE) ratio values

ROE is expressed as a percentage. The higher the ratio, the more efficient the company was in
utilizing invested capital.

For most of the twentieth century, the ROE of S&P 500 companies average between 10 to 15%. In
the 1990’s, the average return on equity was in excess of 20%.

Disadvantages of using the Return On Equity (ROE) ratio

ROE is sensitive to leverage.  Assuming that proceeds from debt financing can be invested at a
return greater than the borrowing rate, ROE will increase with greater amounts of leverage.

Because the numerator (Net Income) is not always reliable, it can be inflated by accounting
practices, the value of ROE alone is also not completely reliable. ROE alone cannot be used to
judge a company, but it can be used in conjunction with other measures.

The degree to which Return On Equity (ROE) overstates the underlying economic value depends on
several factors:

1. Depreciation: Depreciation rates faster than straight-line basis will result in a lower net
income and therefore also in a lower ROE.
2. Growth rate of new investment: Faster growing companies will have lower Return On
Equity because they need more equity.
3. Length of project life: The longer lifespan a project has, the more likely the ROE is going
to be overstated.
4. Capitalization policy: The smaller the fraction of total investment is capitalized in the
books, the greater will be the overstatement of ROE.
5. Lag between investment outlays and their recoupment: The longer it takes to recoup
profits, the greater the degree of overstatement.

The ROE ratio has other names too.

Other names for the Return On Equity (ROE) ratio

Return On Equity (ROE) is known also as Return on Net Worth (RONW).

Alternative calculation
In some cases the Return on Equity may be modified using the following formula:

                      Net Income - Preferred Dividends

Return on Equity = -------------------------------------
                              Common Equity

Preferred dividends are subtracted from net income.

Preferred equity is subtracted from shareholders' equity.

Is there any other ratio related to this?

Yes, finance practicioners use many other ratios when they analyze finance. For example the
following:

Acid Test Ratio,

Capital Adequacy Ratio (CAR),

 Return On Assets (ROA),

Return on Investment (ROI),

or the Cash Asset Ratio (CAR).

Free Cash Flow (FCF)

 Finance & Business

 Financial Measures

Free Cash Flow (FCF) is the amount of cash that a company has left over after it has paid all of
its expenses, including investments. It is the cash that a company is able to generate after laying
out the money required to maintain or expand its asset base.

Free Cash Flow (FCF) is a measure of financial performance calculated as operating cash flow (net
income plus amortization and depreciation) minus capital expenditures and dividends.

How is Free Cash Flow FCF used?

Free Cash Flow is a source of financing. It allows companies to takeadvantage of new
opportunities. Without free cash flow, a company would be unable to develop new products,
acquire other businesses, pay off debt, and pay dividends to shareholders.

Implications for shareholders

Free Cash Flow is also closely tied to the amount of cash that is left over for the stockholders. The
more free cash flow a company has, the more likely it is to pay high dividends.

Free Cash Flow FCF in layman terms

To produce revenue, a firm incurs operating expenses. That is for example office paper, paper
clips, free coffee. In more broad terms, it would be especially the following:

o salaries,
o cost of goods sold (CGS),
o selling and general administrative expenses (SGA),
o research and development (R&D)).

The difference between operating revenue, that is what the firm gets from customers, and
operating expense, the list of things above, is called Operating Income or Net Operating Profit
(NOPAT).

A firm also must buy machinery, buildings, tools, and other things. The firm must invest money in
real estate, buildings, and equipment.

In addition to this, a firm also needs to buy inputs for its production. It has to buy lumber if it
wants to manufacture showels. In financial terms, a firm has to purchase working capital to
support its business activities.

On top of that, a corporation must pay income taxes on its earnings.

The amount of cash that is left over after the payment of all these expenses, investments, and
taxes is known as Free Cash Flow (FCF).

Formula for the Free Cash Flow FCF

Free Cash Flow (FCF) can be calculated in two ways.

   Net Operating Profit

 - Taxes
--------------------------------
 = NOPAT
 - Net Investment
 - Net Change in Working Capital
--------------------------------
 = Free Cash Flow (FCF)

Or, alternatively:

   Net Income
 + Amortication/Depreciation
 - Changes in Working Capital
 - Capital Expenditures
(- Dividends)
--------------------------------
 = Free Cash Flow (FCF)

The Dividends are in parentheses because some analysts include them, some do not. When
analyzing Free Cash Flow, it is important to always know how the figure was calculated.

Is there any other ratio related to this metric?

Yes, financial practice know many other ratios, for example the following:

Cash Asset Ratio (CAR),

Capital Adequacy Ratio (CAR),

Acid Test Ratio,

Current Ratio (CuR),

Return On Assets (ROA),

Return on Investment (ROI),

or the Return On Equity (ROE).

Quick Ratio (QuR) and Acid-Test Ratio

 Finance & Business

 Financial Measures
The Quick Ratio (QUR) is a model or a method used for measuring the liquidity of a company by
calculating the ratio between all assets quickly convertible into cash and all current
liabilities.

It specifically excludes inventory.

Quick Ratio is an indicator of the extent to which a company is able to pay current liabilities
without relying on the sale of inventory.

Formula for the Quick Ratio QUR

                  Cash + Accounts Receivable
Quick Ratio = ---------------------------------
                      Current Liabilities

            Cash + Accounts Receivable

               + Cash Equivalents
       = ----------------------------------
             Accruals + Accounts Payable 
                  + Notes Payable

Values of Quick Ratio QUR

In most cases a QUR of 1:1 or higher indicated a good financial health and suggests that a
company does not have to rely on the sale of inventory to pay the bills.

Other names related to the Quick Ratio QUR

This ratio is also known as the Acid-Test Ratio.

Disadvantages of using the Quick Ratio QUR

A thing to remember when using the QUR model is that it ignores timing of both cash received and
cash paid out.

Let's assume a company with no bills due today, but it has a lot of liabilities that are due
tomorrow. The company also owns a lot of inventory (part of its current assets). However the
inventory cannot be easily converted into cash.  It takes some time to sell it.  This company may
show a good quick ratio but can not be considered as having a good liquidity.

Alternative calculation
                 Current Assets - Inventories
Quick Ratio = ---------------------------------
                      Current Liabilities

Is there any other ratio related to this metric?

Yes, financial practice know many other ratios, for example the following:

Free Cash Flow (FCF),

Cash Asset Ratio (CAR),

Capital Adequacy Ratio (CAR),

Current Ratio (CuR),

Return On Assets (ROA),

Return on Investment (ROI),

or the Return On Equity (ROE).

Price/Earnings Ratio (P/E Ratio)

 Finance & Business

 Financial Measures

The Price/Earnings Ratio, also Price-to-Earnings Ratio, or shortly the P/E ratio, is a

valuation metric of a company's current share price compared to its per-share earnings. The P/E
ratio looks at the relationship between the stock price and the company’s earnings.

The P/E ratio is the most common measure of how expensive a stock is. People use it so popularly
mainly because it is so simple.

The P/E ratio does not work very well as a timing device, but it can provide some idea of whether
the market is "cheap" or "expensive".

How P/E is calculated?

The price/earnings ratio or the P/E ratio is equal to a stock's market capitalization divided by its
after-tax earnings over a 12-month period.

               Market Value per Share

P/E ratio = ----------------------------
              Earnings per Share (EPS)

The Earnings per Share (EPS) is usually taken from the last four quarters. Then, the P/E ratio is
called trailing P/E.

Earnings per Share (EPS) can sometimes be taken from the estimates of earnings expected in the
next four quarters. Then, the P/E ratio is called projected or forward P/E.

In some cases, P/E ratio can be calculated by taking the sum of the last two actual quarters and
the estimates of the next two quarters.

What are the implications of high P/E ratio?

In general, the higher the P/E ratio, the more the market is willing to pay for each dollar of annual
earnings. Investments in stock of companies with high P/E ratios are more likely to be considered
risky because a high P/E ratio signifies high expectations. Some investors read a high P/E as an
overpriced stock.

Investments with low P/E ratios are chaper and less risky.

The P/E is the most popular metric of stock analysis, but it is important that it must not be blindly
considered alone. It is one of many metrics that give the picture.
What does a low P/E ratio mean?
A low P/E may indicate a low confidence in the company by the market.

However, it could also mean that the stock just has been overlooked by the market and represents
a potential for gain. Some investors made their fortunes spotting these companies some times
called diamonds in the rough.

What is the right P/E?

There is no good answer to this question. That is because the answer depends on perception. What
is a good price for shoes? Someone will buy shoes for $30 while someone else will consider $35 a
good deal too based on the information that is available to him or her.

The "right" P/E ratio depends on the investor's willingness to pay for earnings.

The more an investor is willing to pay, which means he or she believes the company has good long
term prospects over and above its current position, the higher the "right" P/E is for that particular
stock.

Nevertheless, the P/E ratio can provide some clue about whether the market is "cheap" or
"expensive". See the S&P500 historical values:

P/E Ratio: apples to apples

When comparing investments, it is necessary to keep in mind what we are comparing. Comparing
P/E ratios is most valuable for companies within the same industry.

For example, companies in the IT industry tent to have higher P/E than companies in the food
industry. That is because IT industry is believed to have higher expected margins and be more
profitable (but also more risky though), thus investors are willing to pay more for what they hope
they will get.

Alternative names
Also sometimes known as price multiple, earnings multiple, or price-to-earnings ratio.

Cash Asset Ratio (CAR)

 Finance & Business

 Financial Measures

The Cash Ratio (CaR) or Cash Asset Ratio (CAR) is a method or a formula for capturing the

liquidity of a company by comparing company's cash reserves and liabilities.
CAR tells the investor how liquid or implicitly solvent the company is. A company may have a great
profit but still be unable to pay its suppliers on time. This ratio analyzes this point of view.

The CAR model measures only the most liquid of all assets against current liabilities and is
therefore seen as the most conservative of the three liquidity ratios.

How Cash Asset Ratio CAR is calculated?

Ratio between all cash and cash equivalent assets and all current liabilities.

It excludes both inventory and accounts receivable in comparison to the Current Ratio.

              Cash Equivalents + Cash

Cash Ratio = -------------------------
                Current Liabilities

               Cash Equivalents + Cash

   = ----------------------------------------------
       Accruals + Accounts Payable + Notes Payable

Other names for Cash Asset Ratio CAR

This CAR ratio is also known as the Liquidity Ratio and Cash Ratio.

What Cash Asset Ratio CAR says

The formula is an indicator of the extent to which a company can pay current liabilities, and now
the important piece, without relying on the sale of inventory and without relying on the receipt of
accounts receivables. It simply tells the investor where the company stands in terms of being able
to pay right now.

Disadvantages of Cash Asset Ratio CAR

It is important to remember that Cash Ratio formula ignores timing of both cash received and
cash paid out.

Are there any other ratios related to the Cash Ratio?

Yes, finance practicioners use other ratios when they analyze statements. For example
the Current Ratio, Return On Assets (ROA), or the Quick Ratio (QuR), also called Acid Test
Ratio.