Enterprising Investor Forum

We ofter hear talk of investors seeking ‘alfa’ or wanting to know what the ‘beta’ is but what do they actually mean? Well, here goes an attempt to try and simplify these terms:

• Alfa: essentially, this is simply a measure of risk-adjusted performance. It will tell you how a stock or fund has performed relative to the benchmark. For example, if the figure is 2.0, it means 2% above the index and -2.0, 2% below.
• Beta: measures volatility, or what is called ’systematic risk’, of a stock vs. the whole market. The actual calculation is made through regression analysis but basically, you should just keep in mind that it will give you an idea of how the stock is likely to react/respond to market movements. A beta of 1.0 means that the stock will tend to move in-line with the market, under 1.0 that it is less volatile and above 1.0 that it is more volatile (i.e. 1.5 will indicate a tendency to be 50% more volatile than the market).

We hope that this makes things a bit easier to understand.

This ratio helps us measure a company’s financial leverage. It shows us what portion of the equity and debt the company is using to finance its assets.

The debt to Equity ratio is calculated by dividing Total Liabilities* by Total Equity.

A ratio that is higher than “1″ indicates that the company’s assets are mainly financed with debt, whereas a ratio of less than “1″ indicates that the company’s assets are primarily supplied by equity. Generally speaking, the more leverage the company has, the higher the ratio and the more aggressive the company has been in financing its growth with debt.

*Please note that sometimes the ratio is calculated only using interest-bearing, long-term debt instead of Total Liabilities.

The Quick Ratio is calculated by dividing Current Assets minus Inventories by Current Liabilities.

Like the Current Ratio, the Quick Ratio (or Acid-Test) is a measure of how well the comapny can pay off its liabilities. However, due to the fact that we subtract the inventory, the ratio becomes a more rigorous test of liquidity. The reason we take away the inventory is becasue it is generally considered as the least liquid of the current assets.

Ideally, the ratio will be equal to “1″ or lower. However, if the result in lower than 0,8, then the business could end up suffering financial difficulties. Furthermore, if the Quick Ratio is significantly lower that the Current Ratio, then this is an indication that the company is heavily dependent upon inventory.

The Current Ratio is calculated by dividing Current Assets by Current Liabilities.

This ratio show us how well a company is able to pay off its short-term debt using its most liquid assets over the next 12 months (short-term solvency).

A ratio of “1″ would mean that the company can pay off its short-term debt. Higher than “1″ would mean that it still has cash left over to operate and under “1″ would mean that it cannot pay off its short-term debt.

As a Value Investor, you will be looking for a ratio higher than 1 and ideally around 1.5. Please note that if the current ratio is too high, then the company may not be efficiently using its current assets.

The PEG ratio is a variation of the P/E ratio. It compares a company’s P/E to its earnings growth and is increasingly used due to the fact that it factors in growth.

The PEG ratio is calculated by dividing the current share price by the Earnings per Share (EPS), divided by the Annual Earnings per Share Growth.

Like the P/E ratio, a lower PEG indicates that the stock may be undervalued. If the PEG is equal to 1, it means that the stock is priced at a level exactly matching the Earnings Growth. Therefore, if it is under 1, it may be an indication that it is undervalued and overvalued if over 1.

The main thing to keep in mind when examining a PEG ratio is what periods were used for the calculation. Growth rates, for example, could be calculated based on historical or projected growth and could be for different durations (i.e. 1 year vs. 5 years). The same is true of earnings, which could be historical or projected.

The P/E ratio tells us how much an investor is willing to pay for every dollar of earnings that a company generates. Generally, a high P/E ratio suggests that there is an expectation for higher earnings growth and therefore an expectation for the company to appreciate in value. This ratio is also known as “price multiple” or “earnings multiple”.

As with most ratios, the number alone can be misleading. It is important to compare the P/E ratio of companies within the same industry, to the market in general or against the company’s own historical P/E.

You will probably come across general benchmarks ranging from 12 to 20 but we strongly encourage you to do your own research because as you can imagine, industries vary considerably (i.e. P/E ratios in the technology sector are usually around 40 vs. 8 for the textile sector).

Just because a company’s P/E ratio is going down, does not mean that the company’s prospects are decreasing. It could simple mean that earnings are growing at a faster pace than the stock price and that this could be an interesting trigger to open a position. Furthermore, please note that companies with negative earnings (meaning that they are actually losing money) do not have a P/E ratio.

The P/E ratio is calculated by dividing the current share price by Earnings per Share (EPS).

Book Value shows us the account value of a company. In other words, if the company were liquidated, this is what the shareholders would theoretically receive.

In most cases, the market value of a company (current stock price) will be higher than the accounting book value. When analyzing this specific variable, investors look for a company where the book value is:

1. Lower than the industry average book value.
2. Close or equal to the book value for that specific company.
3. In extreme cases, lower than the book value for that specific company (please note that if the result is substantially lower, it could mean that there is something seriously wrong with the company).

Why is the book value generally higher in the open market? Because the market price takes into account expectations of future growth and profitability which are not accounted for in the balance sheet.

The Price-To-Book Ratio (P/B Ratio) is calculated by dividing the last closing price of the stock by total assets minus intangible asset and liabilities.

This is one of the most widely used ratios when trying to asses a company’s performance. Most analysts use this as the primary variable to determine the share price.

In order to calculate EPS you have to divide the profit attributable to ordinary shareholders by the weighted average of shares outstanding during the financial period. The result is the net income that is being generated per share of the company.

As already mentioned, since this ratio is so important, you will see that analysts are constantly issuing revised earnings estimates. Why? Because, earnings are the most important factor that affects the value of a company. Earnings are the profit a company makes, and a company cannot survive without earnings.

You should not compare the EPS of different companies due to different strategies in terms of numbers of shares outstanding. The most useful way to use this ratio is to look at the growth in EPS over time, which will help us understand the company’s progress.

You have probably heard people saying that the common language of business is finance and therefore, when dealing with ratios, the most important are those that are financially based.

We plan to use this category to explain not only, how some of the key ratios are calculated but more importantly what they mean and how to interpret them. In our search for truly exceptional businesses that are currently trading at discounted prices, we have to be able to asses the business fundamentals: basically we are looking for value.

Assets, profits, growth and cash flow will be the inputs that will allow us to generate the ratios and enable us to determine this corporate value. However, please remember that this is only part of the equation, when trying to understand a business and future growth potential, we also have to consider key issues like management, competitive advantage and moats.

Stay tuned for our first post on Earnings per Share (EPS).