Growth, Return, & Performance Ratios & Metrics
Not enough investors know about the different ways of calculating growth. There is a big difference between the arithmetic growth rate and the geometric growth rate
#51 Arithmetic Growth Rate
The arithmetic growth rate is the simple average of returns. As an example, let’s assume a stock has the following returns over three years:
- Up 25%
- Down 50%
- Up 25%
Under these assumptions the arithmetic average growth rate is 0% per year. You might think you came out at break-even using the arithmetic growth rate, but that is not the case…
In reality your portfolio would be down 22%.
This is explained in the geometric growth rate section below.
#52 Geometric Growth Rate
The geometric growth rate is also called the compound growth rate or the time series growth rate.
Remember our example from above? In the real world, compounding matters. The geometric growth rate takes into account compounding, also called growth through time.
Imagine you have the following annual returns:
- Up 25%
- Down 50%
- Up 25%
To calculate the geometric growth rate you would do the following:
This comes to -7.9% a year, which is a decidedly poor return (and not even close to the 0% growth rate the arithmetic average would’ve calculated).
The formula for using the geometric growth rate is below:
#53 Total Return
Total return is stock price appreciation (or depreciation) plus dividend payments. It is the total return from an investment, including capital gains and dividends.
Total return is typically used when calculating performance as dividends are often a large portion of total returns.
#54 Survivorship Bias
Survivorship bias is a common error in thinking and studies. It is when you look only at the surviving stocks in a study, and not at the ones that dropped out.
As an example, if you were to calculate the return of all Dividend Aristocrats since 2000 and only looked at the ones that are still Dividend Aristocrats you would have survivorship bias in your study. This is because the study did not take into account the stocks that were Dividend Aristocrats, but cut their dividends between year 2000 and now.
Valuation Ratios, Metrics and Formulas
There is no one "correct" way to value a business. There are, however, a wide variety of financial ratios and metrics that can be used to compare the relative value of stocks to one another.
#55 Price-to-Earnings Ratio
The price-to-earnings ratio is one of the most important investing metrics to know. It is a quick way to broadly gauge the sentiment around a stock.
The higher the price-to-earnings ratio, the more you must pay for $1 of a company’s earnings. All other things being equal, a high price-to-earnings ratio signals the market expects rapid growth from a company while a low price-to-earnings ratio signals expected low or negative growth.
At a price-to-earnings ratio of 20, you must pay $20 for every $1 of annual earnings from the company. The price-to-earnings ratio is calculated as share price divided by earnings.
#56 Enterprise Value to EBITDA
There is significant evidence that the Enterprise Value to EBITDA ratio is one of the two best valuation metrics. It has historically outperformed the following metrics:
- Price-to-earnings
- Enterprise value to free cash flow
- Enterprise value to gross profit
- Price-to-book
It appears that using enterprise value instead of market cap (which is the same as price) in the denominator of value ratios improves results. This is likely because enterprise value takes into account total capital structure, including debt and cash. In its simplest form, enterprise value is calculated as follows:
Businesses with large amounts of cash on their balance sheet and no debt score better with enterprise value than they do with market capitalization.
Using EBITDA is also beneficial. EBITDA is perhaps the best measure of showing how much cash a business is generating irrespective of capital structure, taxation and depreciation.
The biggest downside to EBITDA is that it does not account for depreciation. This is rather troubling, as depreciation is a real part of cash flows. Using EBIT in place of EBITDA is preferable from a conceptual standpoint.
#57 Enterprise Value to EBIT
Not only is using EBIT in place of EBITDA preferable from a conceptual standpoint, it is also preferable from a historical return standpoint.
In the book Quantitative Value, Tobias Carlisle and Wesley Gray demonstrate that the Enterprise Value to EBIT multiple has outperformed the EBIDTA to Enterprise Value multiple (and all other valuation metrics) from the period 1964 to 2011.
For investors looking for a single valuation metric, Enterprise Value to EBIT is likely the best.
#58 Enterprise Value to Free Cash Flow
This metric is similar to the two above. Instead of using EBIT or EBITDA in the denominator, it uses free cash flow. Free cash flow comes from the statement of cash flows rather than from the income statement and is preferable when one believes a company may not be correctly stating earnings. Cash doesn’t lie.
#59 Price to Sales
The price to sales metric uses the very first item on the income statement – sales. The advantage the price to sales ratio has over others is that it works for virtually all businesses. Not all businesses are profitable, but nearly all have sales.
The price to sales ratio helps to compare businesses that may not be profitable currently, or that are experiencing a temporary decline in profit margins.
#60 Price-to-Book Value
The price-to-book ratio compares the price of a stock to its book value. This ratio works well for businesses that rely on assets or equity to produce cash flows. It is not well suited for franchises and does not work at all on businesses with negative equity.
#61 Price to Tangible Book Value
Tangible book value is book value minus intangible assets and goodwill. It looks only at "real" assets and ignores goodwill and other intangibles. The price-to-tangible book value ratio can be used in place of the price-to-book value ratio when one feels that a company’s intangible assets are obscuring the true value of assets.
#62 Forward Price-to-Earnings Ratio
The forward price-to-earnings ratio divides the current price by next year’s expected earnings. The ratio is useful when a business’ current year earnings are significantly understated or overstated by large one time events.
#63 Price-to-Earnings to Growth Ratio (abbreviated PEG)
The PEG ratio was popularized by Peter Lynch. It is calculated as follows:
The PEG ratio takes into account growth rate when considering valuation. This is intuitive. A company growing at 10% a year should have a higher price-to-earnings ratio than a company growing at 2% a year. The PEG ratio takes this into account.
A PEG ratio below one is generally said to be a bargain.
#64 Modified Price to Earnings to Growth Ratio
The PEG ratio does not take into account dividend payments. Dividends can be a large part of total returns. The modified PEG ratio does take dividends into consideration.
The formula for the modified PEG is below:
#65 Shiller Price-to-Earnings Ratio
The Shiller price-to-earnings ratio (also called PE10) uses average earnings over the last 10 years instead of trailing 12-months earnings in the denominator.
This technique is beneficial for cyclical businesses or businesses with rapidly fluctuating earnings. This site has a very long-term perspective on the S&P 500’s PE10 ratio.
#66 Negative Enterprise Value
Unlike the preceding valuation tools, negative enterprise value is not a ratio. A business has a negative enterprise value when it has enough cash on its books to completely pay off all its debt AND buy back all its shares.
This does not (or very, very, rarely) happens to profitable businesses. If you identify a business with a negative enterprise value, it is ripe for a takeover or acquisition. If the business were to be acquired, all the cash could be distributed to shareholders and the business be shut down, which would result in positive returns with very little risk.
You can see a list of negative enterprise value stocks here. Be sure to check data yourself, and use a screener as the first step in the investing process. Always do your due diligence.
#67 Discount to Net Current Asset Value
Net current asset value is calculated as current assets minus total liabilities.
Net current asset value is commonly abbreviated as NCAV.
Benjamin Graham generated returns of around 20% a year over several decades by investing in a diversified portfolio of companies trading at 67% or less of their NCAV.
The idea behind NCAV is if a business is trading for less than the value of its current assets less all liabilities, it is very certainly undervalued. Benjamin Graham wanted a large margin of safety (hence the 67% of NCAV) on this type of investment.
In today’s market, there are very few NCAV stocks available. NCAV stocks become more common during deep bear markets.
#68 Discounted Cash Flow
Discounted cash flow analysis is a method of finding the "fair value" of a business. Discounted cash flow analysis is the correct way to value an investment if you have 100% perfect information on the future.
Discounted cash flow analysis discounts the sum of all future cash flows of a business back to present value using an appropriate discount rate.
Assuming you have misplaced your crystal ball and your psychic powers have stopped working, discounted cash flow analysis has serious flaws because it requires so many assumptions.
Discounted cash flow analysis requires the following assumptions:
- Discount rate
- Growth rate
- When earnings stream will start and stop
Because of this the fair value derived from discounted cash flow analysis. With that said, the metric does have utility in bringing to forth the assumptions you are making in your valuation and how it effects the total value of a stocks.
#69 Earnings Yield
The earnings yield is the inverse of the price-to-earnings ratio. It shows what percentage of money would be returned to you by a company at a current price if you owned the business and distributed 100% of net profit.
#70 Magic Formula
The magic formula was popularized by successful hedge fund manager Joel Greenblatt (Trades, Portfolio) in "The Little Book That Beats the Market."
The Magic Formula ranks stocks on two metrics:
- Rank based on EBIT/Enterprise Value
- Rank based on EBIT/(net fixed assets + working capital)
The first ranking signal in the magic formula works very well. The second signal adds no value and actually decreases returns from the first signal as evidenced in the book "Quantitative Value."
The idea behind the Magic Formula is to find:
- Undervalued businesses
- Businesses with strong competitive advantages
The EBIT/Enterprise Value metric works well to find undervalued businesses.
The other metric (which Greenblatt refers to as Return on Capital) does not work well in identifying businesses with strong and durable competitive advantages.
It is also important to note that Greenblatt’s claims of 30% annual returns from the magic formula are disputed and cannot be independently verified by other historical studies.
#71 Net-Net Working Capital
Net-Net Working Capital stocks are business trading below liquidation value. They are extremely cheap (and often for good reason).
When a business trades for below liquidation value, a little good news can send the stock surging upwards as it is priced for nothing but negativity.
The formula to calculate net-net working capital (abbreviated as NNWC) is below:
Benjamin Graham created and popularized NNWC investing. NNWC capital stocks are very rare in today’s investing world. NNWC stocks tend to provide very high returns over time (similar to NCAV and Negative Enterprise Value stocks).
NNWC investing is a form of deep value investing.
#72 Shareholder Yield
Shareholder yield shows how much cash an investment is returning to shareholders as compared to its price.
Shareholder yield (in its most basic form) is calculated as:
Businesses with high shareholder yields show that the company is:
- Trading at a low price relative to cash returned to shareholders
- Has a shareholder-friendly management that looks to reward shareholders with cash
#73 Graham Number
Benjamin Graham pioneered value investing. As a result, many of the metrics in the valuation section come from him.
The Graham Number looks to find the maximum acceptable price for a well-established business. The Graham Number is calculated as:
The Graham Number finds the maximum fair value to pay for a business. As an example, if a company has $1 in earnings-per-share and $5 in book-value-per-share, the Graham Number would be $10.61. If the stock was trading for under $10.61 a share it would be a buy (though Graham would likely look for a margin of safety on top of this).
Balance Sheet & Debt Risk Metrics
The ultimate risk facing any business is insolvency. Having a high debt burden makes a business going bankrupt more likely because it must constantly pay creditors. The metrics below take a variety of approaches to looking at a businesses’ ability to handle its debt burden.
#74 Equity to Assets Ratio
The equity to assets ratio shows the percentage of assets owned by the company.
The formula to calculate the equity to assets ratio is equity divided by assets.
The higher the equity to assets ratio, the greater percentage of the company’s assets that are owned by the company and not from debt purchases.
#75 Cash Flow to Debt Coverage Ratio
This ratio is calculated as operating cash flows divided by total debt.
The higher the ratio, the quicker a company can pay off its debts. If the ratio is above one, the company could use its cash flows to pay off its debt in under a year.
#76 Quick Ratio
The quick ratio is used to determine a company’s short-term liquidity situation.
It is calculated as:
The quick ratio is designed to show if a company is able to meet its short-term liabilities. If the quick ratio is below one, the company is at serious risk of bankruptcy as it does not have enough cash on hand to pay debts coming due in the next year.
The higher the quick ratio, the better.
The quick ratio is also known as the acid test ratio.
#77 Debt to Equity Ratio
The debt to equity ratio is calculated as total liabilities divided by equity.
The ratio is used to calculate how leveraged a company is relative to its owned value (as measured by equity).
Highly leveraged businesses are at greater risk of insolvency as they must continuously meet their debt holder payment obligations.
#78 Interest Coverage Ratio
The interest coverage ratio is commonly calculated as EBIT divided by interest expense.
The higher the interest coverage ratio, the better.
The interest coverage ratio shows how well-covered a company’s interest expenses are by its earnings before interest and taxes.
Any business with an interest coverage ratio below one is in serious danger.
An interest coverage ratio above 1.5 is the threshold for "not at immediate risk." Most stable businesses have interest coverage ratios far higher than 1.5.
Technical & Momentum Ratios and Indicators
The metrics below use stock price data to determine optimal entry and exit points for investing.
#79 52 Week Range
Fifty-two week range is the high and low price of a stock over the last year. As an example, if a stock had a high price of $60 over the last year and a low price of $40 over the same time period, its 52-week range would be $40 to $60 per share.
Momentum investors typically look to buy near the 52-week high, while value investors will be more interested in stocks trading near the 52-week low.
#80 Momentum
Momentum can be measured in a large variety of ways. At its core it is a measure of the past performance of a stock.
Positive momentum has been shown to produce market-beating returns over the next month. The first widely credited large study on the subject was done by Jegadeesh and Titman in 1993.
The most widely used measure of momentum is 12-month performance, skipping the most recent month (11 months of performance data). This is because the first month is associated with mean reversion and is therefore not included in momentum calculations.
While momentum has been shown to produce excess returns on par with value investing (and even outpacing it), momentum investing is not suitable for long-term investors as it involves significant buying and selling (in general; there are momentum-based asset class strategies with lower turnover).
#81 Simple Moving Average
The simple moving average is a metric often used to determine when an asset should be held, and when it should be sold.
The most common simple moving average used is the 200-day simple moving average. Securities that are trading above their 200-day simple moving average have been shown to have higher returns than when trading below their 200-day simple moving average. This is very likely the same (or similar) effect that is picked up with past performance momentum.
#82 Relative Strength Index (abbreviated RSI)
The relative strength index compares recent gains to recent losses. The goal of the relative strength index is to determine if a security is overbought or oversold.
The formula for the relative strength index is below:
RSI ranges from 0 to 100. When the RSI is 70 or above the security is said to be overbought. When the RSI is 30 or below it is said to be oversold.
#83 Average True Range
Average true range is often abbreviated as ATR.
The average true range is another way to measure the volatility of a security.
Average true range is calculated as a simple moving average (often 14 days) of a company’s true range.
True range is calculated as the highest of the following:
- High in a period minus low in a period
- Absolute value of period high minus previous close
- Absolute value of the period low minus previous close
Capital Asset Pricing Model & Portfolio Ratios & Metrics
The metrics below are used in modern portfolio theory and the capital asset pricing model. In addition, metrics used to examine portfolio characteristics are included in this section.
#84 Alpha
Alpha is "excess return." It is return greater than what one would expect from an investment using the capital asset pricing model. High positive alpha shows one is outperforming the market while controlling for risk (as measured by Beta).
#85 Risk Free Rate of Return
The risk-free rate of return is the return you could generate from a "riskless asset."
The term is a bit of a misnomer as no asset is truly risk free.
The proxy most often used for the risk-free rate is the yield on Treasury bills. The one-year Treasury bill currently has a yield of 0.55% a year.
#86 WACC
WACC stand for weighted average cost of capital.
The WACC shows the blended cost of debt and equity financing for a company. The formula for WACC is below:
The cost of equity is the average investor expected return from the common stock. This is unknowable. In practice. The most common way to calculate the cost of equity is to use the capital asset pricing model. The formula for the capital asset pricing model (abbreviated as CAPM) is below:
Example:
- Risk free rate is 4%
- Expected market return is 9%
- Beta is 1.5
In this case, the stock’s cost of equity is 11.5%.
Calculating the cost of debt is easier. The cost of debt is the weighted average interest rate on debt. Since interest rates reduce taxes, a tax shield adjustment is made on the cost of debt. This is the (1-Tax Rate) portion of the WACC formula.
Continuing with our example:
- Cost of equity is 11.5%
- Equity financing is 60%
- Debt financing is 40%
- Cost of debt is 8%
- Tax rate is 30%
In this case the WACC is 9.14%.
The WACC is useful in determining what projects a company should take on. A business should never take on projects with a projected rate of return below the WACC.
#87 R-Squared
R-squared is a measure of how well data fits a linear regression. R-squared ranges from 0% to 100%. One hundred percent is a perfect fit, while 0% means your model does not explain your data at all.
In investing R-squared measures how much of a fund or portfolio's returns can be explained by underlying market movement.
#88 Active Share
Active share measures how different a fund or portfolio’s holdings are from the benchmark. The greater the difference, the higher the active share.
Higher active share is somewhat correlated with outperforming the market. One cannot hope to outperform a benchmark by much if active share is low, as the portfolio is too similar to the benchmark.
#89 Tracking Error
Tracking error shows the difference in performance between a fund or index and its benchmark. For ETFs, a large tracking error is negative because the ETF is not tracking the benchmark it should be.
#90 Correlation
Correlation measures how securities move together.
Correlation ranges from -1 to 1. A score of -1 is a perfect inverse relationship. A score of 1 is perfect relationship; the securities move in lockstep with each other. A score of 0 shows no relationship at all.
Investing in a wide variety of securities with positive expected returns and low correlations is the goal of a diversified portfolio. In practice, this is very difficult as most asset classes see their correlations converge when you need them not to – during market corrections.
Alternative Earnings Metrics
Earnings is not the only way to calculate money "to the goods" a business generates. This section looks at several alternatives to earnings that investors can use to track how much money a company is making.
#91 Owner’s Earnings
Owner’s earnings is the earnings metric Warren Buffett (Trades, Portfolio) uses. To calculate owner’s earnings, do the following:
- Start with earnings
- Add back depreciation and amortization
- Add back non-cash charges
- Subtract maintenance capital expenditures
- If working capital increased, subtract change in working capital
- If working capital decreased, add change in working capital
The difficult part of calculating owner’s earnings is finding maintenance capital expenditures.
Maintenance capital expenditures are not a normal part of financial statements. Investors must dissect capital expenditures and estimate how much was used for growth and how much for maintenance.
#92 FFO
FFO stands for funds from operations.
This metric is commonly used for REITs instead of earnings. Since REIT’s assets are their primary business, depreciation significantly impacts results. Depreciation accounting rules often do not match up with real world depreciation. This makes FFO necessary.
FFO is calculated as net income excluding gains or losses on the sale of property, with depreciation added back in. FFO is a much better profitability measure for REITs than earnings.
#93 AFFO
AFFO stands for Adjusted Funds From Operations.
It takes funds from operations and adjusts for recurring capital expenditures, as well as other adjustments from management. AFFO is typically the most representative measure of "real earnings" from REITs.
Miscellaneous Descriptive Ratios & Metrics
#94 Short Ratio
The short ratio is also called short float. It shows the percentage of tradeable shares being sold short. The higher the short ratio, the more investors are betting a stock’s price will fall. Stocks with high short ratios tend to have serious questions regarding their underlying business model.
#95 Insider Ownership
Insider ownership is the percentage ownership in a business by the following:
- Shareholders with more than 10% ownership of the company
- Officers and directors of the company
#96 Institutional Ownership
Institutional ownership is the percentage of ownership of a stock by large "sophisticated" investors such as hedge funds, ETFs, mutual funds, private equity funds and pension funds.
Large institutional ownership generally means a stock will be well-covered. On the downside, high institutional ownership can lead to big swings in a stock’s price as institutional investors tend to buy and sell together.
Other Business Performance Ratios & Metrics
#97 Cash Conversion Cycle
The cash conversion cycle is used to measure how quickly a company can convert cash on hand into even more cash on hand.
The cash conversion cycle is broken down into three parts:
- Days Sales of Inventory (abbreviated as DSI)
- Days Sales Outstanding (abbreviated as DSO)
- Days Payable Outstanding (abbreviated as DPO)
The cash conversion cycle is calculated as DSI + DSO – DPO.
#98 Days Sales of Inventory
Days sales of inventory measures the average length of time a company’s cash is tied up in inventory before it is sold.
Days sales of inventory is calculated as:
The lower the days sales of inventory is, the quicker a business can convert its inventory into sales.
#99 Days Sales Outstanding
Days sales outstanding calculates how long a company takes to collect on its sales. Days sales outstanding is calculated as:
The lower the days sales outstanding is, the faster a company can collect on its payments.
#100 Days Payable Outstanding
Days payable outstanding measures how long a company can wait before paying back its creditors. It is calculated as follows:
The higher the days payable outstanding, the more free credit a company can squeeze out of its supplies.
#101 Inventory Turnover Ratio
Inventory turnover ratio shows how many times in one year a company’s inventory is being replaced. The higher the inventory turnover ratio, the quicker inventory is "flying off the shelves" and (in general) the more demanded a company’s products are.
The inventory turnover ratio is calculated as sales divided by average inventory in a period.
