Wednesday, August 16, 2006
In Singapore, when you divide one no. by another, it is usually to achieve some specific purpose and you will forget all about it in like 2 seconds. E.g. you go to a restaurant with 12 friends and when you get the bill, you simply divide it by 12, and forget all about it.
On Wall Street, when you divide one no. by another, it has divine meaning. Cult leaders and religious factions are formed. So much so that some no.s have an ® mark beside them. And R stands for Religion.
Ok R does not stand for Religion, but it is true that some no.s when divided by another has an ® mark beside them. These no.s are also known as financial ratios.
Wall Street thinks that by divided one no. by another, you can normalize things and hence comparison can be made for different co.s. Much as I despise Wall Street, I think that sometimes ratios make sense. E.g. when I divided the dollar value of all the presents I bought for my wife by the no. of times I skip washing dishes, I can determine the efficiency of the presents. It works out to be $12.6 for per dishwashing session. Anyone needs some financial planning on dishwashing?
Anyway, below is a non-exhaustive list of financial ratios and their meanings.
1) Operating Margin (OP/Sales): Efficiency of the firm's operations, this no. range from -90% to +90%, the higher the better.
2) Asset Turnover (Sales/Total Asset): Efficiency of the firm's assets in creating sales, this no. is usually 1.x, the higher the better.
3) Return on Equity (Net Profit/Equity): Rate of return attributed to shareholders, this no. is usually 5-40%, on average around 20%, the higher the better.
4) Return on Asset (Net Profit/Total Asset): Rate of return attributed to the whole firm, this no. is usually 2-30%, the higher the better.
5) Dividend Yield (Dividend per share/Share Price): Rate of return of dividends, this no. is usually 0% to 10%. In Singapore, anything higher than 5% is considered very good.
6) Other ratios that we talked about: PER, PBR, Net debt-to-equity, cash-to-market cap, EV/EBITDA.
7) Another 10,016 ratios that we did not talk about, created by Wall Street analysts. Maybe you can still find 1 or 2 useful ratios in there.
Essentially ratios are quite useful when you want to analyze a company but try not to be a cult leader and read into ratios religiously. By that I mean you try to contemplate if $12.5 per dishwashing session is more efficient that $12.6 per dishwashing session. They are useful but not that useful. They give a sense of how the company is performing, you still need to do more homework after that.
See also How to read financial statements?
Labels: Financial Ratios