Compare Asset Turnover across Different Sectors

In the article “Calculate Asset Turnover Ratio”, we explained what asset turnover ratio is and why it is important to a company. We also used Caterpillar’s real net income statement and balance sheet to show how to calculate a company’s asset turnover ratio. Furthermore, in the article “DuPont Equation and Its Implication”, it is showed that actually asset turnover ratio is one of the components that affect company’s return on equity. In this article, we are going to compare asset turnover ratio across different sectors to see if asset turnover ratio difference exists or not.

Methodology

Sector Categorization

We categorize companies into nine sectors based on Yahoo Finance definition. The nine sectors are Basic Materials, Conglomerates, Consumer Goods, Financial, Healthcare, Industrial Goods, Services, Technology, and Utilities.

Company Selection

Among all tradable companies, we choose those that can be traded by options. The reason for that is because we would like to select companies that have certain liquidity. The company that can be traded by options means that they have certain liquidity. Currently there are 2825 companies that is option tradable.

Profit Margin Calculation

1. use Stock Financial Statements Download (SFSD) to batch download all target companies’ most recent net income and balance sheet statement
2. calculate each company’s asset turnover ratio by formula: Revenue/Average Total Asset
3. Compile the calculated company asset turnover according to the sector it belongs to
4. use the median asset turnover number of the specific sector to represent the sector’s profit margin
Note the median is used instead of average to avoid the distortion due to long tail distribution

Result

Following table is the calculation result
 


There are several observations we can make from this table:
1. Among those 9 sectors, Consumer Goods and Services have high asset turnover ratio
2. If we take a look at the compiled data from article “Compare Profit Margin across Different Sectors”, consumer goods and service sectors have low profit margin.
3. For Consumer Goods sectors, we do expect to see low profit margin and high asset turnover ratio because consumer products tend to have low profit margin and company earns profit by high volume sales. As for Services sector, need to investigate further to find out the reason.
4. Financial Sector has extremely low asset turnover ratio

Further Analysis

We can further breakdown the data more into different industries inside each sector. Click here to download the raw data
By investigating industry breakdown data, we can found out the reason why Services sector also has high asset turnover ratio is because some industries in Services sector are actually retailers such as drugs wholesale. The real ‘service’ industries such as business service and management service do have low asset turnover ratio and that’s what we expect.
Following is the screenshot of asset turnover ratio distribution among Services sector.
 

Compare Profit Margin across Different Sectors

In the article “Calculate Profit Margin”, we explained what is profit margin and why it is important to a company. We also used Caterpillar’s real net income statement to show how to calculate a company’s profit margin. Because profit margin is a ratio to measure a company’s profitability, we would like to know if different business sectors have different profit margin due to the nature of the business operation. In this article, we are going to compare profit margin across different sectors to see if profit margin difference exists or not.

Methodology

Sector Categorization

We categorize companies into nine sectors based on Yahoo Finance definition. The nine sectors are Basic Materials, Conglomerates, Consumer Goods, Financial, Healthcare, Industrial Goods, Services, Technology, and Utilities.

Company Selection

Among all tradable companies, we choose those that can be traded by options. The reason for that is because we would like to select companies that have certain liquidity. The company that can be traded by options means that they have certain liquidity. Currently there are 2825 companies that is option tradable.

Profit Margin Calculation

1. use Stock Financial Statements Download (SFSD) to batch download all target companies’ most recent net income statement
2. calculate each company’s profit margin ratio by formula: Net Income / Revenue
3. Compile the calculated company profit margin according to the sector it belongs to
4. use the median profit margin number of the specific sector to represent the sector’s profit margin
Note the median is used instead of average to avoid the distortion due to long tail distribution

Result

Following table is the calculation result

Sector	Sample Number	Median Profit Margin
Financial	521	0.17
Utilities	92	0.08
Technology	518	0.06
Industrial Goods	232	0.06
Basic Materials	357	0.06
Consumer Goods	253	0.05
Services	574	0.04
Healthcare	274	0.04
Conglomerates	4	0.035

There are several observations we can make from this table:
1. In this particular year (2012), financial sector has incredibly high profit margin compared to other sectors. We believe it has something to do with rebound from financial crises.
2. Exclude Financial sector, utilities sector has the highest profit margin, followed by technology, industrial goods, and basic materials sectors
3. Conglomerates sector has the lowest profit margin. However, it’s hard to make a conclusion because the sample is too small (only 4)

Further Analysis

We can further breakdown the data more into different industries inside each sector. Click here to download the raw data


From the breakdown table, we can see that there are some industries that could have high profit margin even though the sector they belong to has low profit margin. Take Cigarettes industry for example, it belongs to consumer goods sector, which has median profit margin 5%. However, this industry has median profit margin 25%.
We can plot the raw data to see the distribution:
It is obvious that even belongs to the same sector, profit margin across different industries can be huge different. Take consumer sector for example, cigarettes industry can have 25% profit margin, while farm products industry only has 1% profit margin

DuPont Equation and Its Implication

In the article “Calculate Profit Margin”, we mentioned that even though we prefer a company with high profit margin, it does not necessary mean this company has high return on equity. To the end, return on equity (ROE) is still one of the most important ratios to influence investment decisions. However, there is a relationship between ROE and profit margin. In this article, we are going to derive the relationship between ROE and profit margin (DuPont Equation) and explain how to use it to make investment decision.
 

ROE Decomposition

Return on Equity (ROE) is a ratio to measure the return on the shareholder’s equity. That’s the reason why it influences investment decision so much. The formula of ROE is simple:
ROE = Net Income / Average Shareholder’s Equity
Note here we use average shareholder’s equity instead of shareholder’s equity for calculation. It is because shareholder’s equity never constant during the fiscal period. It is better to use averaged shareholder’s equity during the fiscal period than the one at the end of fiscal period.
We can make first level decomposition of the above formula:
ROE = (Net Income / Average Total Assets) * (Average Total Assets / Average Shareholder’s Equity)
In the article “Calculate Financial Leverage”, we showed how to calculate financial leverage from debt-equity ratio. Because a company’s total assets = debt + equity,
=> Average Total Assets / Average Shareholder’s Equity = Financial Leverage
=> ROE = Return on Assets * Financial Leverage
We can further decompose return on assets (ROA):
ROA = Net Income / Average Total Assets
= (Net Income / Revenue) * (Revenue/Averaged Total Assets)
While Net Income / Revenue is profit margin and Revenue / Averaged Total Assets is
Asset turnover ratio
Now we derived the final format of DuPont equation:
ROE = ROA * Financial Leverage
= (Net Income/Revenue) * (Revenue/Averaged Total Assets) * (Averaged Total Assets/Averaged Shareholder’s Equity)
=> ROE = Profit Margin * Asset Turnover Ratio * Financial Leverage
 

Implication

From the formula above, it implies that we can always breakdown a company’s ROE into three elements: profit margin, asset turnover ratio, and financial leverage. By breaking down a company’s ROE into these three elements allows us to further investigate the main driver of a company’s ROE.
 

High Profit Margin as ROE Driver

Some industries tend to have high profit margin as their ROE driver. That means they tend to sell less units of product but each unit sold need to have high profit margin to have competitive edge
 

High Asset Turnover Ratio as ROE Driver

Some industries tend to have high asset turnover ratio as their ROE driver. That means they try to sell as many goods as possible in order to maintain proper ROE. Sudden drop of sales volume might hurt their ROE
 

High Financial Leverage as ROE Driver

Some industries tend to have high financial leverage as their ROE driver. That means they try to generate profit by borrowing other people’s money. However, high financial leverage accompanies high financial risk.

Calculate Asset Turnover Ratio

In the article “Calculate Profit Margin” and “Calculate Financial Leverage”, we showed how to calculate the profit margin from the company’s net income statement and its financial leverage from the balance sheet statement. In this article, we are going to discuss the asset turnover ratio, which is less heard from public. However, with the understanding of profit margin, financial leverage, and asset turnover ratio, we can breakdown return on equity (ROE) into these three elements and give us more insight in terms of the source of a company’s ROE. We are going to use net income and balance sheet statement from MSN Money website as an example to show you how to calculate asset turnover ratio
 

What is Asset Turnover Ratio

Asset turnover ratio is a ratio to measure business’s efficiency to generate revenue by using its asset. The higher the asset turnover ratio a company has, the more efficient a company is to generate revenue by its asset. The basic idea behind asset turnover ratio is that a company’s asset is a valuable resource. Generally a company increases its asset either from the contribution of shareholders or through the debt issuance. If a company can’t operate its asset efficiently, (e.g. generate revenue) investors might put their resources (money) to somewhere else to have better usage.
Asset Turnover Ratio = Revenue / Averaged total asset
Note we use averaged total asset during the fiscal period instead of total asset at the end of fiscal period because total asset fluctuates during the fiscal period while revenue is generated. It makes more sense to use averaged total asset to calculate the ratio
 

Calculate Asset Turnover Ratio from Net Income and Balance Sheet Statement

Because we need to know both a company’s revenue and averaged total asset in order to calculate asset turnover ratio, we need both the company’s net income and balance sheet statement in order to calculate asset turnover ratio. In the following example, we are going to use net income and balance sheet statement from company Caterpillar (CAT) to show how to calculate Caterpillar’s asset turnover ratio. You can access Caterpillar’s net income statement and balance sheet statement from MSN Money website or you can use or product, Stock Financial Statements Download, to download and export Caterpillar’s net income and balance sheet statement into .CSV format. Followings are screenshots of both downloaded net income and balance sheet statements
 

 

 

From its income statement, Caterpillar has total revenue $65875M in 2012. From its balance sheet statement, Caterpillar has averaged total asset ($81446M+$89356M)/2 = $85401M in 2012
=> Caterpillar’s asset turnover ratio in 2012 = 65875/85401 = 0.77
 

Commentary

So far we have showed you how to calculate a company’s asset turnover ratio based on its net income and balance sheet statement. Take Caterpillar for example, its asset turnover ratio is 0.77 in 2012. That means for every $1 dollar worth of asset, Caterpillar will generate $0.77 dollar revenue. However, just like profit margin, asset turnover ratio itself doesn’t give us a big picture in terms of how the company does overall. It is possible for a company to have high asset turnover ratio yet its ROE is low. In the next article, we are going to introduce DuPont formula and show you the relationship among ROE, profit margin, financial leverage, and asset turnover ratio.

Calculate Gross Margin

In the article “Calculate Profit Margin” and “Calculate Operating Margin”, we showed how to calculate the profit margin and operating margin from the company’s net income statement. In this article, we are going to discuss the gross margin and show the equation and steps how to calculate operating margin from company’s net income statement. Also we are going to explain the difference between gross margin and markup. We are going to use net income statement from MSN Money website as an example to show the calculation
 

What is Gross Margin

Similar to Profit Margin and Operating Margin, Gross Margin is also one of the ratios to measure business’s profitability. The basic idea behind gross margin is to measure how profitable for every one unit of product the business sold before accounting other expenses. For example, if you own a coffee shop and for each coffee you sold for $3. In order to make a cup of coffee, you have to purchase coffee beans, coffee machines, paper cup… with total cost $0.3 in average. That means you earn the gross profit of $2.7 for each cup of coffee you sold. From the example about, we can see the gross profit calculation doesn’t include any expenses other than cost directly related to the product itself, such as rent for space, general administration…
=>Gross Margin = Gross Profit / Revenue
Where Gross Profit = Revenue – COGS (Cost of Goods Sold)
COGS (Cost of Goods Sold) is a general term to refer to the inventory cost. From the above example, COGS would mean the cost to purchase coffee beans, paper cup…
 

Difference between Gross Margin and Markup

Many people get confused with gross margin and markup. Basically these are two methods to describe the same thing, but with different purpose. The reason why some retailers prefer gross margin and some prefer markup is because gross margin is easier to calculate the profit from the sales revenue, while markup is easier to calculate sales price from the cost. We can always derive one another from following relation relations:
Markup = Revenue / COGS -1
=> Gross Margin = Markup/ (1+Markup).
=> Markup = Gross Margin / (1-Gross Margin)
 

Calculate Gross Margin from Net Income Statement

We are going to use income statement from company Caterpillar (CAT) to show how to calculate Caterpillar’s operating margin. You can access Caterpillar’s income statement here or you can use or product, Stock Financial Statements Download, to download and export Caterpillar’s income statement.

 


 
From its income statement, Caterpillar has total operating income $18820M and total revenue $65875M in 2012. Because Gross Margin = Gross Profit / Revenue
=> Caterpillar’s gross margin in 2012 = 18820/65875 = 28.57%
Notice that gross profit ($18820M) is derived by total revenue ($65875M) – cost of revenue ($47055M). Instead of calling it COGS (cost of goods sold), MSN Money website called it cost of revenue.
 

Commentary

In the article “Calculate Profit Margin” and “Calculate Operating Margin”, we calculated Caterpillar’s profit margin and operating margin in 2012 as 8.62% and 13.01% respectively. Caterpillar’s gross margin, 28.57%, is higher than its operating margin. It is no surprise that in general a company’s gross margin > operating margin > profit margin because gross profit calculation only includes production related costs and operation profit calculation includes production related costs and other operation costs, while net profit includes all costs

Calculate Operating Margin

In the article “Calculate Profit Margin”, we showed how to calculate the profit margin from business’s financial statement. In this article, we are going to discuss the operating margin and show the equation and steps how to calculate operating margin from company’s net income statement. We are going to use net income statement from MSN Money website as an example to show the calculation
 

What is Operating Margin

Similar to Profit Margin, Operating Margin is also one of the ratios to measure business’s profitability. The only difference is that instead of using net income, operating margin uses operating income to calculate the ratio
=>Operating Margin = Operating Income / Revenue
 

Difference between Operating Income and Net Income

As the name suggested, operating income is income generated solely from operating activity. Take the net income statement of Caterpillar Inc. (CAT) downloaded by Stock Financial Statements Download (SFSD) for example. It is obvious that
Operating Income = gross profit – operating expenses
Where operating expenses = Gross profit - selling general and administrative – research and development – special income/charges – interest income/expense
As for net income, it is derived from operating income minus nonoperation expense
=> Net income = operating income – nonoperation expense
= operating income – net interest income – other income – pretax income – provision for income tax – minority interest

 


 
 

Calculate Operating Margin from Financial Statement

We are going to use income statement from company Caterpillar (CAT) to show how to calculate Caterpillar’s operating margin. You can access Caterpillar’s income statement here or you can use or product, Stock Financial Statements Download, to download and export Caterpillar’s income statement.

Calculate Profit Margin

In the article “Calculate Financial Leverage”, we showed how to calculate the financial leverage from business’s financial statement and debt equity ratio. In this article, we are going to discuss the profit margin and show the equation and steps how to calculate profit margin from company’s financial statement, basically net income statement.

What is Profit Margin

Profit Margin is one of the ratios to measure business’s profitability. The basic idea behind this measurement is to see how efficient the business generates revenue based on cost accrued. If the business can generate more revenue based on less cost, it is more efficient, and hence has higher profit margin
=> Profit Margin = (Revenue – Cost)/Revenue
Because Revenue – Cost is simply Net Income
=>Profit Margin = Net Income / Revenue

Calculate Profit Margin from Financial Statement

We are going to use income statement from company Caterpillar (CAT) to show how to calculate Caterpillar’s profit margin. You can access Caterpillar’s income statement here or you can use or product, Stock Financial Statements Download, to download and export Caterpillar’s income statement.
Following is screenshot how it looks like using Stock Financial Statements Download to export it into local PC



From its income statement, Caterpillar has total revenue $65875M and net income $5681M in 2012. Because Profit Margin = Net Income / Revenue
=> Caterpillar’s profit margin in 2012 = 5681/65875 = 8.62%

Commentary

Profit Margin is used to measure business’s profitability. Higher profit margin generally indicates the company has higher profitability. However, from investors’ point of view, high profit margin doesn’t mean it will have high return on equity, which is the major ratio investors are looking for. It is possible that a company can have high profit margin yet its return on equity is low. Besides that, profit margin may vary among different industries. However, it is still a valuable indicator because investors can calculate the profit margin year by year based on the company’s historical financial statement for internal comparison

Compare Financial Leverage across Different Sector

In the previous article “Calculate Financial Leverage”, we explained what financial leverage is and its effect for the company’s return on equity. We also used Starbucks’ financial report as an example to show the way to calculate the financial leverage. Even though there is no guide line in terms of the amount of financial leverage the company should take, it seems that different business sectors would have different financial leverage due to the nature of the business. In this article, we are going to investigate this assumption and see if it is true.
 

Methodology

Sector Categorization

We categorize companies into nine sectors based on Yahoo Finance definition. The nine sectors are Basic Materials, Conglomerates, Consumer Goods, Financial, Healthcare, Industrial Goods, Services, Technology, and Utilities.
 

Company Selection

Among all tradable companies, we choose those that can be traded by options. The reason for that is because we would like to select companies that have certain liquidity. The company that can be traded by options means that they have certain liquidity. Currently there are 2253 companies that is option tradable.
 

Financial Leverage Calculation

For each selected company, we calculate its financial leverage simply by dividing its return on equity by its return on assets. After the financial leverage ratio for all companies are calculated, we choose the median of all companies belong to a certain sector to represent the financial leverage for that particular sector. Note the median is used instead of average to avoid the distortion due to long tail distribution
 

Result

Following table is the calculation result

Sector	Sample Number	Median FL
Technology	428	1.875
Basic Materials	322	1.935
Healthcare	204	1.98
Services	449	2
Industrial Goods	183	2.03
Consumer Goods	209	2.13
Conglomerates	9	2.37
Utilities	77	2.6
Financial	372	5.475

There are several observations we can make from this table:

1. Technology, Basic Materials, and Healthcare have financial leverage below 2
2. Services, Industrial Goods, Consumer Goods, and Utilities have financial leverage between 2 to 3
3. Comparing to the other eight sectors, Financial sector has much higher financial leverage (5.475)
Following is the financial leverage distribution comparison between Technology sector (lowest financial leverage) and financial sector (highest financial leverage)
 

Commentary

From the analysis above, there is a strong correlation between the amount of financial leverage companies take and the sector companies are at. It can be explained by the nature of business. In order for a technology company such as Apple to prosper, it requires the company to have sufficient cash all the time to support its research and development work. On the other hand, a company in financial sector such as Bank of America generates profit by using other people’s money (deposit). That explains why it has much higher financial leverage than other sectors

Calculate Financial Leverage

In the previous article “Debt Equity Ratio and Debt Ratio”, we discussed the relationships between debt-to-equity ratio and debt ratio and showed the formula to derive either one from the other. In this article, we are going to discuss the financial leverage and show the relationships between financial leverage and debt-to-equity ratio and use Starbucks as the example to show the calculation of financial leverage from its income and balance sheet statement

What is Financial Leverage

Financial leverage is a ratio to measure the multiply effect on the original return. Although there are many techniques to achieve this, the simplest way for a company to leverage its equity is by borrowing money. Let’s use Starbucks’ financial statement to explain how Starbucks multiplies its return by borrowing money. Here is the link to Starbucks’ income statement and balance sheet statement.

Calculate Financial Leverage from Financial Report

From its income statement, Starbucks has net income $1245.7M in 2011. Also from its balance sheet, Starbucks’ averaged Total Assets during 2010-2011 is $6873.15M ((7360.4+6385.9)/2). That gives Starbucks’ Return on Assets (ROA) 18.12% (1245.7/6873.15). However, from the investor’s point of view, the return is higher than 18.12%. When we purchase Starbucks’ stock, we become the stake holders of the company. That means we own a portion of the company’s equity depends on how many shares we have. In that sense, the actual return from the investor’s point of view should be calculated by using averaged Total Equity instead of averaged Total Assets.
From its balance sheet, Starbucks’ averaged Total Equity during 2010-2011 is $4029.8M ((4384.9+3674.7)/2). So the Return on Equity (ROE) for Starbucks is 30.91% ($1245.7M/$4029.8M), which is 1.71 x 18.12%. Because part of Starbucks’ assets is debts, it is able to generate higher return and we call the ratio 1.71 financial leverage

Calculate Financial Leverage from Debt Equity Ratio

From the above example, we can see that financial leverage = Return on Equity / Return on Assets, while Return on Equity = Net income / Averaged Total Equity, and Return on Assets = Net Income / Averaged Total Assets
=> Financial Leverage= Averaged Total Assets / Averaged Total Equity
= (Averaged Total Liabilities + Averaged Total Equity) / Averaged Total Equity
=> Financial Leverage = Debt-to-Equity Ratio + 1
Take Starbucks for example, it has averaged total liabilities $2843.35M ((2975.5+2711.2)/2) and averaged total equity $4029.8M. That gives us debt-to-equity ratio = 0.71. Because financial leverage ratio is also = Debt-to-Equity Ratio + 1, we get the same financial ratio 1.71

Commentary

The formula we derived above is convenient because Debt-to-Equity ratio is a common ratio that we can get. Simply add 1 to the debt-to-equity ratio then we can get the financial leverage ratio

Debt Equity Ratio and Debt Ratio

In the previous article, we briefly talked about debt equity ratio and mentioned that debt equity ratio is related to the company’s financial leverage. However, many investors confuse debt equity ratio and debt ratio. Actually debt equity ratio is not the same as debt ratio but either one can be derived by the other one. In this article, we are going to explain the relationship between debt equity ratio and debt ratio

Debt Equity Ratio

Debt equity ratio is calculated by dividing a company’s total liabilities by stockholder’s equity:
Debt Equity Ratio = Total Liabilities / Total Equity (Eq. 1)
It gives investors an idea how a company has been aggressively borrowing money to grow its business. High debt equity ratio indicates that the company is aggressively expanding its business by using a large portion of capital that is not its own. If the incremental profit generated by expanding is higher than the cost of interests, the company is generating more profit compared to the scenario had company not borrowed the money. On the other hand, the company could generate larger than expected loss if the result doesn’t go well.

Debt Ratio

Similar to debt equity ratio, debt ratio is calculated by dividing a company’s total liabilities by its total assets, which is a company’s total liabilities plus total stockholder’s equity
Debt Ratio = Total Liabilities / Total Assets (Eq. 2)
From Eq. 1 and Eq. 2, we can derive:
Debt Ratio = Debt Equity Ratio / (1+Debt Equity Ratio) (Eq. 3)
Note from Eq. 3 we can see that Debt ratio always greater than or equal to 1 since debt equity ratio can’t be less than 0
Based on the equation above, we can easily calculate the debt ratio based on debt equity ratio.

Application

The concept of debt ratio can not only apply to individual company but also can apply to industry or sector level. If we use Stock Market Browser to investigate the debt equity ratio of 9 sectors, we see the sector Industrial Goods has the highest debt to equity ratio while Basic Material has the lowest debt to equity ratio.
 


 

We can apply Eq. 3 to calculate these two sectors’ debt ratio:
For sector industrial goods, its debt ratio = = 65.64%
For sector Basic Materials, its debt ratio = = 27.54%

Commentary

Although debt equity ratio is used more frequently, both debt equity ratio and debt ratio give investors the same information. However, debt equity ratio is more convenient when calculating a company’s financial leverage, which we will discuss in the next article

Debt to Equity Ratio in Stock Market Browser

Stock Market Browser is a tool that can give you a quick snapshot of the total stock market from sector down to individual stock. One of the financial ratios it provides to you is Debt to Equity ratio. However, the meaning of Debt to Equity ratio in Stock Market Browser is different from the traditional meaning of Debt to Equity ratio. In this article, we are going to use Caterpillar’s most recent balance sheet provided by Yahoo Finance to show the calculation of Debt to Equity ratio in Stock Market Browser and compare the number from traditional Debt to Equity ratio. Following is Caterpillar’s quarterly balance sheet from Yahoo Finance:

Traditional Meaning of Debt to Equity Ratio

Normally, Debt to Equity Ratio is defined a company’s total liabilities divided by a company’s averaged shareholders’ equity

From Caterpillar’s balance sheet of most recent quarter, it has total liabilities 68.09B and averaged total shareholders’ equity (12.883B + 14.162B)/2 = 13.52B. Based on the formula above, its debt to equity ratio would be 68.09 / 13.52 = 5.04
However, this number is different from the number provided by Stock Market Browser:



You can find out Caterpillar (CAT) under sector Conglomerate and industry Conglomerate.
As of 04/02/2012, Debt to Equity ratio provided by Stock Market Browser is 258

Derive Debt to Equity Ratio in Stock Market Browser

First of all, the unit of this ratio is 100%. That means 258 is actually 258%. So how Stock Market Browser derives 2.58?
Instead of using total liability to represent total debt, Stock Market Browser only use item “Long Term Debt” and “Short/Current Long Term Debt” to represent total debt. In other words, it only considers total long term debt as real debt.
Based on Caterpillar’s balance sheet of most recent quarter, it has short/current long term debt 9.648B and long term debt 24.944B. The Debt to Equity Ratio would be (9.648+24.944)/13.52 = 2.58, which is 258%
 

Conclusion

In the traditional definition, the company’s total liabilities is used to represent the total debt, but Stock Market Browser only uses total long term debt, which is the portion of liabilities that accrues the most of interest. Because it only uses the portion of liabilities that accrues the most of interest, the ratio can give investors a better measurement in terms of financial leverage and risk.

PE and PEG Ratio

PE ratio probably is one of the most wildly used ratios for investors to make the investment decision. The reason might be because it is easy to understand and it simplifies the decision making. However, it might be misleading by only looking at the PE ratio

What is PE Ratio?

PE ratio stands for price-to-earnings ratio. It is the current stock price divided by the annual net income (earnings) per share (EPS). For example, if stock XYZ is trading at $20 and its annual earnings per share is $2, the PE ratio would be $20/$2 = 10

Implication of PE Ratio

PE Ratio is usually used to compare to the yield of other investment alternatives. From investors’ point of view, when they buy a stock with PE ratio 10, it can be treated that this investment has annual return on investment 10% (you paid $20 for a stock that can earn $2 in a year). With that mindset, you can compare to other investment alternatives to determine the relative attractiveness. (Remember the article Market Risk Premium 101?)

You can also compare the stock’s current PE ratio to its historical PE ratio to get a sense whether the stock is relatively cheap at this point of time. For example, if stock XYZ was trading at PE 100 last year but is currently trading at PE 10, it seems this stock is relatively cheap at this point of time

Can’t Make Investment Decision by PE Alone

However, there are traps here by making investment decision purely using PE ratio:
1. Stock price fluctuates all the time: Even though we say that PE ratio 10 can be treated the same as 10% annual yield, there is no guarantee the stock price won’t go down. It is possible that stock XYZ is trading at $20 now with PE ratio 10 but goes down to $10 after one year. Besides that, depends on the company policy, you don’t really benefit immediately from $2 earnings if the company doesn’t pay any dividend

2. Earnings fluctuate year over year: Even though a stock might seem to be expensive at this point of time, that doesn’t automatically make it a poor buy. The trap here is that earnings will change year over year. For example: if stock XYZ has average PE ratio 10 historically and is currently trading at $20 with past 12 month earnings $1, its PE ratio is 20. It seems to be expensive now. Suppose this company is doing very well for the next year so that after one year, its past 12 month earnings increased to $2.5. If stock price is still trading $20, its PE ratio changes to 8. If we have crystal ball to tell us the company XYZ is going to have earnings $2.5 for the next year, that will make this stock’s current trading price ($20) a good buy. Unfortunately, no one has crystal ball.

Important of the Expectation of Earnings Growth Rate

From the above example, not only PE ratio but also the expectation of the future earnings growth rate will affect the stock price. If investors believe that the company XYZ is going to have high earnings growth rate, they might be willing to pay higher price to own its stock even that means buy at high PE ratio. On the other hand, if investors believe that the company XYZ is going to have slow or negative earnings growth rate, PE ratio of that company’s stock tends to be low. As you can see, because no one has crystal ball, it is the “expectation”, not the “real”, future earnings growth rate that drive the stock price up and down.

Introduction to PEG Ratio

PEG ratio of a particular stock is its PE ratio divided by its expected annual EPS growth rate, as a percentage. The rationale behind this calculation is that if stock is trading at high PE, it is expected to have high EPS growth rate, and vice versa. For example: if stock XYZ currently is trading at PE ratio 10 and its expected EPS growth rate is 10%, the PEG ratio of stock XYZ is 10/10 = 1. Because PEG ratio take stock’s annual EPS growth rate into consideration, many investors use PEG ratio to determine if a stock is under or overvalued. The lower the PEG ratio, the better (more undervalued) the stock is (same PE with high EPS growth rate or same EPS growth rate with low PE).

In Practice

We can use Stock Fundamental Data Download to see the current PEG ratio distribution of companies listed in Down Jones. The PEG ratio number is extracted from Yahoo Finance. It is based on the expectation of the next 5 years growth rate. Following is the result sorted by PEG Ratio.



As of today (02/16/2012) GM has the lowest PEG ratio (0.41) while T has the highest PEG ratio (3.39) among Down Jones stocks. If you pay attention to the dividend yield, you see that in general companies have low PEG ratio pays little dividends compared to companies have high PEG ratio. It is obvious that there is always a tradeoff in terms of investment. The final decisions really depend on your ultimate goal, which could be different among individuals.

Let us emphasize one more time, No matter what the data source is, the annual EPS growth rate you see is the “expected” number because no one can foresee what will happen in the future. That’s the reason why you will see the dramatic price movement of some stocks after the earning is announced.

Ex-Dividend Date and Dividend Pay Date

In the previous article Introduction to Dividend Yield, we talked about several investment strategies that are based on dividend yield. Since part of the strategies are based on the amount of dividend you receives, it is important to know the difference between stock ex-dividend date and dividend pay date. the reason is that because stocks are constantly traded and hence the ownerships are constantly changed. Joe bought stock XYZ in Jan, 1 and sold it in Feb, 1 to Mary. In Mar, 1, Mary sold it to Peter. If stock XYZ is going to pay the dividend in April, 1, Who is in title to receive the dividend?

What is Ex-Dividend Date

The ex-dividend date sometimes is called the reinvestment date.  It is the date to determine if you will be in title to receive the dividend of the stock you own. The official definition from IRS is “the first date following the declaration of a dividend on which the buyer of a stock is not entitled to receive the next dividend payment”. Probably you are still confused. Simply put, it means that if want to be in title to receive the dividend of the stock XYZ, you have to buy this stock before ex-dividend date. If you buy the stock XYZ on or after ex-dividend date, you won’t be in title to receive the dividend.

What is Dividend Pay Date

In terms of dividend pay date, it is much straightforward. It is the date that dividend is actually paid to the stock owner that are in title to receive the dividend

In Practice

In the previous article Introduction to Dividend Yield, we mentioned about the strategy that invests in stocks that have the highest dividend yield. By using Stock Fundamental Data Download, we can sort the stock by its dividend yield as following



So currently stock T (AT&T) has the highest dividend yield among Dow Jones stocks with Ex-Dividend Date Jan, 6 and Dividend Pay Date Feb, 1. That means if you want to be in title to receive the next dividend payment paid by AT&T in Feb, 1, you have to buy the stock before Jan, 6
You might think about buy AT&T stock in Jan, 5 then sell in Jan, 6. In that way, you can receive the next dividend simply by holding the stock one day. However, because it is public information and everyone knows about it, the stock price already factors in this information so when you try to sell AT&T stock in Jan, 6. the stock price should have already reduced by the dividend amount that is going to be paid in Feb, 1

Introduction to Dividend Yield

Simply put, dividend yield is the amount of annual dividends per share divided by the stock price per share. For example, if a company pays annual dividend $5 and currently the company’s stock is trading at $50, the dividend yield is 5/50 = 10%. Many investors prefer high dividend yield stock rather than high growth stock without dividend payment. The reason is because in general it seems to be safe to hold high dividend yield stock especially when the outlook of the economy is uncertain. Think about it: The only way to profit by investing in the stock that doesn’t pay the dividend is through the stock price appreciation. However, investors can profit from high dividend yield stock simply by receiving the dividends. It is very attractive when everyone thinks the economy won’t be good in the near future.

Dividend Yield Strategies

There are several investment strategies that we can consider by applying dividend yield concept

Dogs of the Dow

Dogs of the Down is a simple strategy that suitable for investors that prefer high dividend yield with passive investment style. Here is how it works: At the beginning of the year, you choose the top 10 highest dividend yield stock in Dow Jones and invest the equal amount of money into each one. By the end of the year you liquidate it and repeat the same process for the next year
You can find the list of Dogs of the Dow for 2012 here
Also you can use the Stock Fundamental Data Download to list the stock from highest dividend yield to lowest dividend yield among Dow Jones stock.



You can also include the ex-dividend date and dividend pay date information. The list is not the same as the list for Dogs of the Down 2012 because it is based on the latest trading data as of Jan, 31, 2012
 

Vertical Sorting of Dividend Yield

Another way is to sort the dividend yield by the segment. Take SPY, which is the S&P 500 index ETF for example, we can dissect SPY into following segment: XLE (Energy), XLF (Finance), XLI (Industry), XLK (Technology), XLU (Utility), XLP (Consumer Staples), XLV (Health Care), XLY (Consumer Discretionary).  Simply load those symbols into Stock Fundamental Data Download and sort them by the dividend yield. Result is as following:



The result shows XLU (utility) has the highest dividend yield and XLK (technology) has the lowest dividend yield

Horizontal Sorting of Dividend Yield

You can also sort the dividend yield horizontally. For example, you might be interested in investing in different countries and wonder what the dividend yield is for each of the country.
Here is an example that we can sort by dividend yield among following 19 countries.



As you can see, among the listed countries, EWP (MSCI Span Index) has the highest dividend yield (9.47%), almost 10%! This high dividend yield reflect the fact that currently investors are not confident in regarding the current debt issue Span is facing

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Comparing the Volatility across Different Assets

 
In the previous article, we showed the steps that everyone can calculate the volatility for particular a particular stock/ETF he or she is interested in. So what’s the general volatility of other assets that we are interested in? In this article, we are going to compare the volatility among four popular assets: equity market, corporate bond, real estate, and gold
 

Popular ETF to Represent Those Assets

Before the invention of ETF, individuals are hard to diversify their portfolio to different asset classes. However, with the increasingly popularity of the ETF, It is easy to get the specific risk exposure you prefer. If you want to get the corporate bond exposure, you can simply buy the corresponding corporate bond ETF just like you buy other stocks. The creation of ETF really helps the individual investors diversify their portfolio without mutual fund managers. Here is the ETF that we are going to use as a practice to measure the volatility for different assets:
Equity Market: SPY
Corporate Bond: LQD
Real Estate: IYR
Gold: GLD
 

Results

As usual, you can use Stock Historical Download or Yahoo Finance to download the historical price to calculate the volatility. The data range we choose is between Jan, 2005 and Jan, 2012. The reason is that because gold ETF GLD was not created until 2005. Different intervals such as 7 years, 5 years, and 3 years are calculated to see the volatility difference among different intervals


As we can see, different asset classes do have different volatility characteristic while the interval chosen to calculate the volatility has small impact in terms of volatility.
It shows that actually real estate (IYR) has the highest volatility, following by gold (GLD), then stock market (SPY). Corporate bond (LQD) has the lowest volatility.  It affirms our general expectation that the risk of bond is lower than stock. On the other hand, the reason why real estate has the highest volatility, which is somewhat contradictory to the traditional view treating real estate investment as a safe investment, might be something to do with the subprime mortgage crisis.

We can also plot the annualized return comparison among those assets


Unlike volatility, the annualized return does fluctuate a lot for different intervals, especially the stock market and real estate. It shows us how difficult it is to profit from timing stock market

Measuring the Risk - Volatility

 
When it comes to investment, in addition to the return on the investment, the other thing that we are always interested in knowing is that how much risk we are taking to make a specific investment. But exactly what is risk? How can we quantify the risk?

Risk VS. Uncertainty

Although there is no clear distinction between the risk and uncertainty, we can use Frank Knight’s distinction as the starting point: Risk has an unknown outcome, but we know what the underlying outcome distribution looks like. Uncertainty also implies an unknown outcome, but we don’t know what the underlying distribution looks like. For example: Amazon is going to announce its fourth quarter earnings in January 31, 2012. As of writing, we don’t know what the price movement of amazon stock is after the earning is announced, but we do have the past history to measure the likelihood of the price movement after earning is announced. That’s the risk. On the other hand, current European sovereign debt crisis posts an uncertainty for us because the outcome is unknown and there is no past history for us to gauge the likelihood of the outcome

Measuring the Volatility of the Stock as the Risk

Although there is no way to measure the uncertainty of a particular stock, we can measure the volatility of the stock according to the past history of price movement to represent the risk of investing in the stock. The volatility of the stock is simply the standard deviation of the price movement for a certain period of time:

Calculate the Risk of the Market (S&P 500)

You can calculate the risk of the market (S&P 500) or any particular stock/ETF you are interested in by following steps:
1. Get the stock historical price data: Use Stock Historical Data Download to download the past 10 years, monthly price movement for symbol S&P 500 (^GSPC)
2. Calculate the monthly price % change based on the monthly price movement
3. Uses the Excel function (STDEV.S) to calculate the volatility for you. Remember you have to times the number by sqrt(12) to make it annualized volatility
You can download the sample excel here
Following is the S&P 500 volatility distribution based on last 10 years, 5 years, 3 years, and 1 year data

The volatility ranged from 16% to 18.9%.
As we can see, the volatility of the stock changes if we use the different intervals of past history
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Market Risk Premium 101

Introduction

When comes to the investment, we might measure the performance of the investment by its nominal return. For example, if the stock you bought in year 1 yields a return 12%, then probably you think this stock is good one to own. On the other hand, if it simply yields a return about 7% in year 2, then you might feel not so good compared to 12% return. However, if further information is revealed that in year 1 the 10-year US treasury bond could give you 8% and in year 2 the 10-year US treasury bond has only 1%, do you still think 12% is better than 7%?
 

High Risk, High Reward

When making the decision in terms of what financial instrument to invest, we are trying to put the money in the one that can give us the best return on investment per risk we take. The main reason why people invest their money in the stock market rather than in the US Treasury bond is because historically it gives us higher return on investment. The reason why we expect to get higher return on investment from stock is because of the fluctuation of the stock price that we might end up losing the principle. With the additional risk we take, extra return is needed to justify investment. It is obvious that if we can get the same return on investment as stock market by investing the money into the US Treasury bond, no one would invest any money into the stock market.
 

Market Risk Premium, the excess return above the risk-free rate

Because of this reason, we are more interested in knowing what’s the excess return above the risk-free rate rather than the nominal return. Take the hypothetical example we mentioned at the beginning, in year 1, the excess return above the risk-free rate would be 12% - 8% = 4%. However, in year 2, the excess return above the risk-free rate would be 7% - 1% = 6%. Actually the stock market performs better in year 2 than in year 1!
 

Estimate the Market Risk Premium

The formula to estimate the market risk premium is simple:
Market Risk Premium = market total return – risk free rate, while market return would be:
(Market Price End – Market Price Beginning + Total Dividend Received) / (Market Price Beginning)
 

Use the Free Data to Calculate the Market Risk Premium Yourself

It would be nice if we can calculate the market risk premium ourselves to get a feel how much excess return do we get in average. Luckily, there are many free data on the internet that we can utilize. Below would be the steps you can follow:^
1. Get SPY ETF historical data: Typically we use S&P 500 index to represent the market. However, it doesn’t have dividend information, so we use SPY, which is the ETF of S&P 500 index to calculate the total market return. You can simply go to Yahoo Finance website to get the data or simply use Stock Historical Data Download to download it for you. Download both monthly quotes and dividend from 1993 to 2012
2. Get ^TNX historical data from Yahoo Finance: the ^TNX historical prices represent the 10-year US Treasury yield. We can use it to represent our risk-free interest rate
3. After putting those data together, we can summarize the result as following:

Year	SPY Begin Price	SPY End Price	Dividend	Total SPY Return	10-Year US Treasury	MRP
1993	31.29	35.24	1.183	16.40%	6.39%	10.01%
1994	35.24	35.51	1.462	4.91%	5.64%	-0.73%
1995	35.51	49.1	1.243	41.77%	7.59%	34.18%
1996	49.1	61.33	0.972	26.89%	5.58%	21.31%
1997	61.33	78.09	1.375	29.57%	6.50%	23.07%
1998	78.09	102.7	1.392	33.30%	5.51%	27.79%
1999	102.7	113.45	1.414	11.84%	4.65%	7.19%
2000	113.45	112.52	1.454	0.46%	6.67%	-6.21%
2001	112.52	93.81	1.032	-15.71%	5.18%	-20.89%
2002	93.81	72.46	1.498	-21.16%	5.03%	-26.19%
2003	72.46	97.11	1.63	36.27%	3.97%	32.30%
2004	97.11	103.05	2.197	8.38%	4.14%	4.24%
2005	103.05	113.15	2.149	11.89%	4.13%	7.76%
2006	113.15	129.93	2.446	16.99%	4.53%	12.46%
2007	129.93	126.46	2.701	-0.59%	4.83%	-5.42%
2008	126.46	78.09	2.721	-36.10%	3.64%	-39.74%
2009	78.09	103.58	2.177	35.43%	2.84%	32.59%
2010	103.58	126.04	1.786	23.41%	3.61%	19.80%
2011	126.04	128.02	2.576	3.61%	3.38%	0.23%
Average						7.04%

From year 1993 to 2011, the market risk premium in average is 7.04%. That means if we invest our money into the stock market during this period instead of 10-year US Treasury bond, the excess return we expect to get is 7.04% annually. However, if we look at the plot, the market risk premium is quite different each year.
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