Call options are financial contracts that give the holder the right, but not the obligation, to buy a specified underlying asset at a predetermined strike price on or before a specified expiration date. Open interest refers to the total number of outstanding contracts that have not been exercised or expired.
In the options market, open interest is a key metric that can provide valuable information about market sentiment and the level of activity in a particular contract. It can be used in combination with other indicators, such as trading volume and price movements, to gain a better understanding of market conditions.
One way that traders use open interest is to determine the level of bullish or bearish sentiment in the market. For example, if the open interest for call options on a particular stock is increasing, it may indicate that traders are becoming more bullish on the stock, as they are buying up more call options. Similarly, if the open interest for put options on a stock is increasing, it may indicate that traders are becoming more bearish on the stock.
Another way that traders use open interest is to gauge the level of liquidity and volatility in a particular contract. A high level of open interest may indicate that there is a large number of buyers and sellers active in the market, which can make it easier to enter and exit trades. This can also make the market more volatile, as there are more participants that can push prices in different directions. A low level of open interest, on the other hand, may indicate that there are fewer traders active in the market, which can make it harder to enter and exit trades and may lead to less volatility.
Open interest can also be used to track the activity of large institutional traders, such as hedge funds and investment banks. These traders often trade in large sizes, and changes in their open interest positions can have a significant impact on the market.
In conclusion, Call options open interest is an indicator that shows the total outstanding number of call options contracts that have not been exercised or expired. It is an important metric that can provide valuable information about market sentiment, liquidity, volatility, and the activity of large institutional traders. Traders use it in combination with other indicators to gain a better understanding of market conditions and make informed trading decisions.
Put options are financial contracts that give the holder the right, but not the obligation, to sell a specified underlying asset at a predetermined strike price on or before a specified expiration date. Like call options, the open interest of put options refers to the total number of outstanding contracts that have not been exercised or expired.
Open interest is an important metric for traders and investors in the options market, as it can provide valuable information about market sentiment and the level of activity in a particular contract. It can be used in combination with other indicators, such as trading volume and price movements, to gain a better understanding of market conditions.
One way that traders use put open interest is to determine the level of bearish or bullish sentiment in the market. For example, if the open interest for put options on a particular stock is increasing, it may indicate that traders are becoming more bearish on the stock, as they are buying up more put options in anticipation of a price decline. Similarly, if the open interest for call options on a stock is increasing, it may indicate that traders are becoming more bullish on the stock.
Another way that traders use put open interest is to gauge the level of liquidity and volatility in a particular contract. A high level of put open interest may indicate that there are a large number of buyers and sellers active in the market, which can make it easier to enter and exit trades. This can also make the market more volatile, as there are more participants that can push prices in different directions. A low level of put open interest, on the other hand, may indicate that there are fewer traders active in the market, which can make it harder to enter and exit trades and may lead to less volatility.
Traders also use put open interest to track the activity of large institutional traders, such as hedge funds and investment banks. These traders often trade in large sizes, and changes in their open interest positions can have a significant impact on the market.
In conclusion, put open interest is an indicator that shows the total outstanding number of put options contracts that have not been exercised or expired. It is an important metric that can provide valuable information about market sentiment, liquidity, volatility, and the activity of large institutional traders. Traders use it in combination with other indicators to gain a better understanding of market conditions and make informed trading decisions.
The put/call open interest ratio is a tool used by traders and investors to determine the level of bullish or bearish sentiment in the options market. The ratio is calculated by dividing the total open interest of put options by the total open interest of call options. This ratio can provide valuable information about the sentiment of market participants and the level of activity in the options market.
A put/call open interest ratio of less than 1 indicates that there is more open interest in call options than in put options, which typically means that the market is bullish. In this case, traders believe that the underlying asset’s price will rise. On the other hand, a put/call open interest ratio of more than 1 indicates that there is more open interest in put options than in call options, which typically means that the market is bearish. Traders believe that the underlying asset’s price will fall.
It’s important to note that the put/call open interest ratio alone can’t be used to predict market direction, but instead should be used in conjunction with other indicators, such as trading volume and price movements, to gain a better understanding of market conditions.
The ratio can also be used to track the activity of large institutional traders, such as hedge funds and investment banks. These traders often trade in large sizes, and changes in their open interest positions can have a significant impact on the market.
Another use for the put/call open interest ratio is for traders who are implementing options strategies as it can be used as a measure to confirm or refute the current market assumptions. A high ratio could indicate that market participants are expecting a bearish market, while a low ratio could indicate that they are expecting a bullish market.
In conclusion, the put/call open interest ratio is a useful tool for traders and investors to gauge the level of bullish or bearish sentiment in the options market. A ratio less than 1 means that there’s more open interest in call options which is a sign of bullishness. A ratio more than 1 indicates that there’s more open interest in put options which is a sign of bearishness. It can provide valuable information about market conditions and the activity of large institutional traders when used in combination with other indicators.
Implied volatility is a measure of the expected volatility of the underlying asset’s price, as implied by the price of its options. It is a theoretical value that is derived from the price of the options using a mathematical model such as the Black-Scholes model.
Implied volatility is an important concept for options traders and investors, as it can provide valuable information about the level of risk associated with a particular option. Generally, options with higher implied volatility are considered to be more risky, as they have a greater potential for price movement in either direction. Options with lower implied volatility, on the other hand, are considered to be less risky, as they have less potential for price movement.
Traders use implied volatility in a number of ways to inform their trading decisions. Some traders use it to measure the level of risk associated with a particular option, while others use it to predict the future price movements of the underlying asset. Some traders also use it to help select options with the right level of risk for their trading strategy.
When implied volatility is high, options prices are generally higher, because they are perceived to be riskier. Conversely, when implied volatility is low, options prices are generally lower, because they are perceived to be less risky.
One of the ways to use implied volatility is through volatility smile. A volatility smile is a graphical representation of the implied volatility for options with different strike prices. It is used to indicate that implied volatility is not the same for all strikes, implying that the market participants have different views on the volatility of the underlying asset. This can be used to find the most profitable options to trade by using the options with highest implied volatility.
In conclusion, Implied volatility is a key metric for options traders and investors. It is a theoretical value that is derived from the options prices using a mathematical model, such as the Black-Scholes model. It measures the expected volatility of the underlying asset’s price. High implied volatility indicates that the option is perceived as riskier, while low implied volatility indicates that the option is perceived as less risky. Traders use implied volatility in a number of ways to inform their trading decisions, and also helps to find the most profitable options by using the options with highest implied volatility and volatility smile.
Implied volatility is a measure of the expected volatility of the underlying asset’s price, as implied by the price of its options. It is a theoretical value that is derived from the price of the options using a mathematical model such as the Black-Scholes model.
Implied volatility is an important concept for options traders and investors, as it can provide valuable information about the level of risk associated with a particular option. Generally, options with higher implied volatility are considered to be more risky, as they have a greater potential for price movement in either direction. Options with lower implied volatility, on the other hand, are considered to be less risky, as they have less potential for price movement.
Traders use implied volatility in a number of ways to inform their trading decisions. Some traders use it to measure the level of risk associated with a particular option, while others use it to predict the future price movements of the underlying asset. Some traders also use it to help select options with the right level of risk for their trading strategy.
When implied volatility is high, options prices are generally higher, because they are perceived to be riskier. Conversely, when implied volatility is low, options prices are generally lower, because they are perceived to be less risky.
One of the ways to use implied volatility is through volatility smile. A volatility smile is a graphical representation of the implied volatility for options with different strike prices. It is used to indicate that implied volatility is not the same for all strikes, implying that the market participants have different views on the volatility of the underlying asset. This can be used to find the most profitable options to trade by using the options with highest implied volatility.
In conclusion, Implied volatility is a key metric for options traders and investors. It is a theoretical value that is derived from the options prices using a mathematical model, such as the Black-Scholes model. It measures the expected volatility of the underlying asset’s price. High implied volatility indicates that the option is perceived as riskier, while low implied volatility indicates that the option is perceived as less risky. Traders use implied volatility in a number of ways to inform their trading decisions, and also helps to find the most profitable options by using the options with highest implied volatility and volatility smile.
Historical volatility is a measure of the volatility of the underlying asset’s price, as observed over a certain period of time in the past. It is calculated by analyzing the past price movements of the underlying asset and measuring how much the price has fluctuated over a certain period. It provides a view of how much volatility has existed in the past and can be used to compare the volatility of different securities or to see if the volatility of a particular security has been increasing or decreasing over time.
Historical volatility is an important concept for options traders and investors, as it can provide valuable information about the level of risk associated with a particular option. Generally, options on underlying assets with higher historical volatility are considered to be more risky, as they have a greater potential for price movement in either direction. Options on underlying assets with lower historical volatility, on the other hand, are considered to be less risky, as they have less potential for price movement.
Traders use historical volatility in a number of ways to inform their trading decisions. Some traders use it to measure the level of risk associated with a particular option, while others use it to predict the future price movements of the underlying asset. Some traders also use it to help select options with the right level of risk for their trading strategy.
One of the common ways to use historical volatility is through volatility measures. such as standard deviation or average true range. These measures provide a quantification of the volatility of a security over a certain period.
Another use of historical volatility is in options pricing models, such as the Black-Scholes model, where it is used as an input to estimate the implied volatility of the underlying asset. The implied volatility can be then compared to the historical volatility to determine if the options are overvalued or undervalued.
In conclusion, historical volatility is a key metric for options traders and investors. It is a measure of the volatility of the underlying asset’s price as observed over a certain period of time in the past. It provides a view of how much volatility has existed in the past and can be used to compare the volatility of different securities or to see if the volatility of a particular security has been increasing or decreasing over time. Traders use historical volatility in a number of ways to inform their trading decisions, such as by using volatility measures, or by comparing it with implied volatility.
Implied volatility is a measure of the expected volatility of the underlying asset’s price, as implied by the price of its options. It is a theoretical value that is derived from the price of the options using a mathematical model such as the Black-Scholes model.
Implied volatility is an important concept for options traders and investors, as it can provide valuable information about the level of risk associated with a particular option. Generally, options with higher implied volatility are considered to be more risky, as they have a greater potential for price movement in either direction. Options with lower implied volatility, on the other hand, are considered to be less risky, as they have less potential for price movement.
Traders use implied volatility in a number of ways to inform their trading decisions. Some traders use it to measure the level of risk associated with a particular option, while others use it to predict the future price movements of the underlying asset. Some traders also use it to help select options with the right level of risk for their trading strategy.
When implied volatility is high, options prices are generally higher, because they are perceived to be riskier. Conversely, when implied volatility is low, options prices are generally lower, because they are perceived to be less risky.
One of the ways to use implied volatility is through volatility smile. A volatility smile is a graphical representation of the implied volatility for options with different strike prices. It is used to indicate that implied volatility is not the same for all strikes, implying that the market participants have different views on the volatility of the underlying asset. This can be used to find the most profitable options to trade by using the options with highest implied volatility.
In conclusion, Implied volatility is a key metric for options traders and investors. It is a theoretical value that is derived from the options prices using a mathematical model, such as the Black-Scholes model. It measures the expected volatility of the underlying asset’s price. High implied volatility indicates that the option is perceived as riskier, while low implied volatility indicates that the option is perceived as less risky. Traders use implied volatility in a number of ways to inform their trading decisions, and also helps to find the most profitable options by using the options with highest implied volatility and volatility smile.
Historical volatility is a measure of the volatility of the underlying asset’s price, as observed over a certain period of time in the past. It is calculated by analyzing the past price movements of the underlying asset and measuring how much the price has fluctuated over a certain period. It provides a view of how much volatility has existed in the past and can be used to compare the volatility of different securities or to see if the volatility of a particular security has been increasing or decreasing over time.
Historical volatility is an important concept for options traders and investors, as it can provide valuable information about the level of risk associated with a particular option. Generally, options on underlying assets with higher historical volatility are considered to be more risky, as they have a greater potential for price movement in either direction. Options on underlying assets with lower historical volatility, on the other hand, are considered to be less risky, as they have less potential for price movement.
Traders use historical volatility in a number of ways to inform their trading decisions. Some traders use it to measure the level of risk associated with a particular option, while others use it to predict the future price movements of the underlying asset. Some traders also use it to help select options with the right level of risk for their trading strategy.
One of the common ways to use historical volatility is through volatility measures. such as standard deviation or average true range. These measures provide a quantification of the volatility of a security over a certain period.
Another use of historical volatility is in options pricing models, such as the Black-Scholes model, where it is used as an input to estimate the implied volatility of the underlying asset. The implied volatility can be then compared to the historical volatility to determine if the options are overvalued or undervalued.
In conclusion, historical volatility is a key metric for options traders and investors. It is a measure of the volatility of the underlying asset’s price as observed over a certain period of time in the past. It provides a view of how much volatility has existed in the past and can be used to compare the volatility of different securities or to see if the volatility of a particular security has been increasing or decreasing over time. Traders use historical volatility in a number of ways to inform their trading decisions, such as by using volatility measures, or by comparing it with implied volatility.
Implied volatility is a measure of the expected volatility of the underlying asset’s price, as implied by the price of its options. It is a theoretical value that is derived from the price of the options using a mathematical model such as the Black-Scholes model.
Implied volatility is an important concept for options traders and investors, as it can provide valuable information about the level of risk associated with a particular option. Generally, options with higher implied volatility are considered to be more risky, as they have a greater potential for price movement in either direction. Options with lower implied volatility, on the other hand, are considered to be less risky, as they have less potential for price movement.
Traders use implied volatility in a number of ways to inform their trading decisions. Some traders use it to measure the level of risk associated with a particular option, while others use it to predict the future price movements of the underlying asset. Some traders also use it to help select options with the right level of risk for their trading strategy.
When implied volatility is high, options prices are generally higher, because they are perceived to be riskier. Conversely, when implied volatility is low, options prices are generally lower, because they are perceived to be less risky.
One of the ways to use implied volatility is through volatility smile. A volatility smile is a graphical representation of the implied volatility for options with different strike prices. It is used to indicate that implied volatility is not the same for all strikes, implying that the market participants have different views on the volatility of the underlying asset. This can be used to find the most profitable options to trade by using the options with highest implied volatility.
In conclusion, Implied volatility is a key metric for options traders and investors. It is a theoretical value that is derived from the options prices using a mathematical model, such as the Black-Scholes model. It measures the expected volatility of the underlying asset’s price. High implied volatility indicates that the option is perceived as riskier, while low implied volatility indicates that the option is perceived as less risky. Traders use implied volatility in a number of ways to inform their trading decisions, and also helps to find the most profitable options by using the options with highest implied volatility and volatility smile.
Total Options Volume for all option contracts during the day
Options trading volume refers to the total number of options contracts that have been traded on a particular underlying asset during a specific period of time. It is an important metric for options traders and investors, as it can provide valuable information about the level of activity in the options market and the level of interest in a particular option or underlying asset.
Traders use options trading volume in a number of ways to inform their trading decisions. One way is by using it to gauge the level of liquidity in the market for a particular option. A high level of options trading volume for a particular option may indicate that there are a large number of buyers and sellers active in the market, which can make it easier to enter and exit trades. A low level of options trading volume, on the other hand, may indicate that there are fewer traders active in the market, which can make it harder to enter and exit trades.
Another way traders use options trading volume is by monitoring large institutional traders such as hedge funds and investment banks. These traders often trade in large sizes, and changes in their trading volume can have a significant impact on the market. Traders can track these large positions and can use them to predict the direction of the market
Traders also use options volume to confirm trends or signals that may be present in other technical indicators. An increase in volume can confirm the trend or signal and may indicate the option is likely to continue in the direction that has been signaled.
Options trading volume is also used to make comparisons between different options and underlying assets. Traders can use this information to identify options and underlying assets that are attracting the most trading volume, which can indicate increased investor interest.
In conclusion, options trading volume is an important metric for options traders and investors as it provides valuable information about the level of activity in the options market, the level of interest in a particular option or underlying asset and the large institutional traders positions. Traders use options trading volume in a number of ways to inform their trading decisions, such as by gauging the level of liquidity in the market, monitoring large institutional traders, and making comparisons between different options and underlying assets. It can also be used to confirm trends or signals from other technical indicators.
Percent Change between that day volume and the average of the previous 5 days
Options trading volume refers to the total number of options contracts that have been traded on a particular underlying asset during a specific period of time. It is an important metric for options traders and investors, as it can provide valuable information about the level of activity in the options market and the level of interest in a particular option or underlying asset.
Traders use options trading volume in a number of ways to inform their trading decisions. One way is by using it to gauge the level of liquidity in the market for a particular option. A high level of options trading volume for a particular option may indicate that there are a large number of buyers and sellers active in the market, which can make it easier to enter and exit trades. A low level of options trading volume, on the other hand, may indicate that there are fewer traders active in the market, which can make it harder to enter and exit trades.
Another way traders use options trading volume is by monitoring large institutional traders such as hedge funds and investment banks. These traders often trade in large sizes, and changes in their trading volume can have a significant impact on the market. Traders can track these large positions and can use them to predict the direction of the market
Traders also use options volume to confirm trends or signals that may be present in other technical indicators. An increase in volume can confirm the trend or signal and may indicate the option is likely to continue in the direction that has been signaled.
Options trading volume is also used to make comparisons between different options and underlying assets. Traders can use this information to identify options and underlying assets that are attracting the most trading volume, which can indicate increased investor interest.
In conclusion, options trading volume is an important metric for options traders and investors as it provides valuable information about the level of activity in the options market, the level of interest in a particular option or underlying asset and the large institutional traders positions. Traders use options trading volume in a number of ways to inform their trading decisions, such as by gauging the level of liquidity in the market, monitoring large institutional traders, and making comparisons between different options and underlying assets. It can also be used to confirm trends or signals from other technical indicators.
Percent Change between that day volume and the average of the previous 30 days
Options volume
Options trading volume refers to the total number of options contracts that have been traded on a particular underlying asset during a specific period of time. It is an important metric for options traders and investors, as it can provide valuable information about the level of activity in the options market and the level of interest in a particular option or underlying asset.
Traders use options trading volume in a number of ways to inform their trading decisions. One way is by using it to gauge the level of liquidity in the market for a particular option. A high level of options trading volume for a particular option may indicate that there are a large number of buyers and sellers active in the market, which can make it easier to enter and exit trades. A low level of options trading volume, on the other hand, may indicate that there are fewer traders active in the market, which can make it harder to enter and exit trades.
Another way traders use options trading volume is by monitoring large institutional traders such as hedge funds and investment banks. These traders often trade in large sizes, and changes in their trading volume can have a significant impact on the market. Traders can track these large positions and can use them to predict the direction of the market
Traders also use options volume to confirm trends or signals that may be present in other technical indicators. An increase in volume can confirm the trend or signal and may indicate the option is likely to continue in the direction that has been signaled.
Options trading volume is also used to make comparisons between different options and underlying assets. Traders can use this information to identify options and underlying assets that are attracting the most trading volume, which can indicate increased investor interest.
In conclusion, options trading volume is an important metric for options traders and investors as it provides valuable information about the level of activity in the options market, the level of interest in a particular option or underlying asset and the large institutional traders positions. Traders use options trading volume in a number of ways to inform their trading decisions, such as by gauging the level of liquidity in the market, monitoring large institutional traders, and making comparisons between different options and underlying assets. It can also be used to confirm trends or signals from other technical indicators.
Total Call Volume ( for all contracts ) in that day
Options call volume refers to the total number of call options contracts that have been traded on a particular underlying asset during a specific period of time. It is a metric used to gauge the level of bullish sentiment in the market for a particular underlying asset and to track the level of activity in the call options market.
Call options give the holder the right, but not the obligation, to buy a specified underlying asset at a predetermined strike price on or before a specified expiration date. When investors and traders buy call options, they are expressing a bullish sentiment on the underlying asset, as they believe the asset’s price will rise in the future. Therefore, monitoring the call options volume can provide valuable information about market sentiment and the level of interest in a particular underlying asset.
Call options volume can be used in combination with other indicators, such as trading volume and price movements, to gain a better understanding of market conditions. A high volume of call options trading for a particular underlying asset may indicate that there is a large number of buyers who are bullish on the asset, which can make it more likely that the asset’s price will rise. Conversely, a low volume of call options trading for a particular underlying asset may indicate that there is less interest in the asset, which can make it less likely that the asset’s price will rise.
Traders also use call options volume to track the activity of large institutional traders such as hedge funds and investment banks. These traders often trade in large sizes, and changes in their call options trading volume can have a significant impact on the market. They can track these large positions and use them to predict the direction of the market.
In conclusion, Options call volume is an important metric used by traders and investors to gauge the level of bullish sentiment in the market for a particular underlying asset and to track the level of activity in the call options market. A high volume of call options trading for a particular underlying asset may indicate that there is a large number of buyers who are bullish on the asset, and conversely, a low volume of call options trading for a particular underlying asset may indicate that there is less interest in the asset. It can also be used in combination with other indicators, such as trading volume and price movements, to gain a better understanding of market conditions and also track the activity of large institutional traders.
Total Put Volume ( for all contracts ) in that day
Put options volume refers to the total number of put options contracts that have been traded on a particular underlying asset during a specific period of time. It is a metric used to gauge the level of bearish sentiment in the market for a particular underlying asset and to track the level of activity in the put options market.
Put options give the holder the right, but not the obligation, to sell a specified underlying asset at a predetermined strike price on or before a specified expiration date. When investors and traders buy put options, they are expressing a bearish sentiment on the underlying asset, as they believe the asset’s price will fall in the future. Therefore, monitoring the put options volume can provide valuable information about market sentiment and the level of interest in a particular underlying asset.
Put options volume can be used in combination with other indicators, such as trading volume and price movements, to gain a better understanding of market conditions. A high volume of put options trading for a particular underlying asset may indicate that there is a large number of buyers who are bearish on the asset, which can make it more likely that the asset’s price will fall. Conversely, a low volume of put options trading for a particular underlying asset may indicate that there is less interest in the asset, which can make it less likely that the asset’s price will fall.
Traders also use put options volume to track the activity of large institutional traders such as hedge funds and investment banks. These traders often trade in large sizes, and changes in their put options trading volume can have a significant impact on the market. They can track these large positions and use them to predict the direction of the market.
In conclusion, Put options volume is an important metric used by traders and investors to gauge the level of bearish sentiment in the market for a particular underlying asset and to track the level of activity in the put options market. A high volume of put options trading for a particular underlying asset may indicate that there is a large number of buyers who are bearish on the asset, and conversely, a low volume of put options trading for a particular underlying asset may indicate that there is less interest in the asset. It can also be used in combination with other indicators, such as trading volume and price movements, to gain a better understanding of market conditions and also track the activity of large institutional traders.
the total put/call volume ratio for all option contracts ( across all expiration dates) traded during the current session
The put/call volume ratio is a tool used by traders and investors to determine the level of bullish or bearish sentiment in the options market. It is calculated by dividing the total volume of put options contracts by the total volume of call options contracts over a specific period of time. This ratio can provide valuable information about the sentiment of market participants and the level of activity in the options market.
A put/call volume ratio of less than 1 indicates that there is more trading volume in call options than in put options, which typically means that the market is bullish. In this case, traders believe that the underlying asset’s price will rise. On the other hand, a put/call volume ratio of more than 1 indicates that there is more trading volume in put options than in call options, which typically means that the market is bearish. Traders believe that the underlying asset’s price will fall.
It’s important to note that the put/call volume ratio alone can’t be used to predict market direction, but instead should be used in conjunction with other indicators, such as trading volume, price movements, and open interest ratio, to gain a better understanding of market conditions.
The ratio can also be used to track the activity of large institutional traders, such as hedge funds and investment banks. These traders often trade in large sizes, and changes in their trading volume can have a significant impact on the market. By monitoring the put/call volume ratio, traders can get an insight into how institutional traders are positioning themselves in the market, which can provide valuable information for trading decisions.
Another use for the put/call volume ratio is for traders who are implementing options strategies. It can be used as a measure to confirm or refute the current market assumptions, A high ratio could indicate that market participants are expecting a bearish market, while a low ratio could indicate that they are expecting a bullish market.
In conclusion, the put/call volume ratio is a useful tool for traders and investors to gauge the level of bullish or bearish sentiment in the options market. A ratio less than 1 means that there’s more trading volume in call options which is a sign of bullishness. A ratio more than 1 indicates that there’s more trading volume in put options which is a sign of bearishness. It can provide valuable information about market conditions and the activity of large institutional traders when used in combination with other indicators.
the ATM average implied volatility relativeto the highest and lowest values over the past 1-year . If IV rank is 100% the means the IV is at its highest level over the past 1-year
Implied volatility rank (IV rank) is a measure used by options traders to compare the volatility of different options contracts or underlying assets. It is calculated by taking the implied volatility of an option or underlying asset and comparing it to the historical volatility of the same option or underlying asset over a specific period of time. The resulting number is then expressed as a percentile, with a value of 100 indicating the highest volatility and a value of 0 indicating the lowest volatility.
IV rank is a useful tool for options traders because it allows them to quickly and easily compare the volatility of different options contracts or underlying assets. It also helps traders identify options contracts or underlying assets that are currently experiencing higher or lower volatility than what is typical for that security, as well as those that may be relatively undervalued or overvalued.
For example, if an option has an IV rank of 75, it means that the current implied volatility of that option is higher than 75% of the historical implied volatility for that option over a certain period. So, if a trader is looking for options that are experiencing higher than usual volatility, they can look for options with a high IV rank. Conversely, if a trader is looking for options that are experiencing lower than usual volatility, they can look for options with a low IV rank.
Traders use IV rank in several ways, such as by comparing it with historical volatility, by using it as an input in options pricing models and using it to predict future price movements. It can also be used in combination with other indicators, such as trading volume and open interest, to gain a better understanding of market conditions.
In conclusion, Implied volatility rank (IV rank) is a measure used by options traders to compare the volatility of different options contracts or underlying assets. It is expressed as a percentile, with a value of 100 indicating the highest volatility and a value of 0 indicating the lowest volatility. IV rank is a useful tool for options traders because it allows them to quickly and easily compare the volatility of different options contracts or underlying assets, and it also helps traders identify options contracts or underlying assets that are currently experiencing higher or lower volatility than what is typical for that security. Traders use IV rank in several ways, such as by comparing it with historical volatility, by using it as an input in options pricing models and using it to predict future price.
% difference between the current volume and the 20-day average volume
Volume change refers to the difference in trading volume of a specific security or underlying asset over a certain period of time. It can be a useful indicator for traders and investors as it can provide insight into the level of buying and selling activity in the market and the level of interest in a particular security or underlying asset.
Traders often use volume change as a confirming indicator to support trends or signals that may be present in other technical indicators. For example, if a stock’s price is rising and the volume is also increasing, this can indicate that there is strong buying interest and that the upward trend in price is likely to continue. On the other hand, if a stock’s price is falling and the volume is decreasing, this can indicate that there is weak selling interest and that the downward trend in price is likely to continue.
Additionally, large changes in trading volume can also indicate potential market turning points. High trading volume can be an indication of a large number of buyers or sellers entering the market, which can cause prices to rapidly change direction. For example, if a stock is in an uptrend and suddenly there is a large increase in volume and the stock starts falling sharply, it is a sign of panic selling, which can indicate that the uptrend is over and that the stock is likely to continue falling.
Volume change can also be used to track the activity of large institutional traders such as hedge funds and investment banks. These traders often trade in large sizes, and changes in their trading volume can have a significant impact on the market. By monitoring the volume change of a price, traders can get an insight into how institutional traders are positioning themselves in the market, which can provide valuable information for trading decisions.
In conclusion, volume change refers to the difference in trading volume of a specific security or underlying asset over a certain period of time and can provide insight into the level of buying and selling activity in the market and the level of interest in a particular security or underlying asset. Traders often use volume change as a confirming indicator to support trends or signals that may be present in other technical indicators and as an indication of potential market turning points or changes in large institutional traders activity. Volume change can be a useful indicator for traders and investors to monitor and analyze when making investment
the numbers of shares or contracts traded for the previous day.
Volume change refers to the difference in trading volume of a specific security or underlying asset over a certain period of time. It can be a useful indicator for traders and investors as it can provide insight into the level of buying and selling activity in the market and the level of interest in a particular security or underlying asset.
Traders often use volume change as a confirming indicator to support trends or signals that may be present in other technical indicators. For example, if a stock’s price is rising and the volume is also increasing, this can indicate that there is strong buying interest and that the upward trend in price is likely to continue. On the other hand, if a stock’s price is falling and the volume is decreasing, this can indicate that there is weak selling interest and that the downward trend in price is likely to continue.
Additionally, large changes in trading volume can also indicate potential market turning points. High trading volume can be an indication of a large number of buyers or sellers entering the market, which can cause prices to rapidly change direction. For example, if a stock is in an uptrend and suddenly there is a large increase in volume and the stock starts falling sharply, it is a sign of panic selling, which can indicate that the uptrend is over and that the stock is likely to continue falling.
Volume change can also be used to track the activity of large institutional traders such as hedge funds and investment banks. These traders often trade in large sizes, and changes in their trading volume can have a significant impact on the market. By monitoring the volume change of a price, traders can get an insight into how institutional traders are positioning themselves in the market, which can provide valuable information for trading decisions.
In conclusion, volume change refers to the difference in trading volume of a specific security or underlying asset over a certain period of time and can provide insight into the level of buying and selling activity in the market and the level of interest in a particular security or underlying asset. Traders often use volume change as a confirming indicator to support trends or signals that may be present in other technical indicators and as an indication of potential market turning points or changes in large institutional traders activity. Volume change can be a useful indicator for traders and investors to monitor and analyze when making investment
the average number of shares/contracts traded over the last 1 month
The 1 month volume average indicator, also known as the 30-day average volume, is a technical indicator that is used to measure the average daily trading volume of a stock or other financial instrument over the past 30 days. It is used to determine the level of interest in a particular stock or underlying asset and to gauge the level of liquidity in the market.
The indicator is calculated by taking the total trading volume of a stock or underlying asset over the past 30 days and dividing it by 30. This provides a snapshot of the average daily trading volume for the past month, which can be used to compare the current volume to the historical average.
Traders and investors often use the 1 month volume average indicator to determine whether a stock is experiencing unusually high or low trading volume. A stock that is trading above its 30-day average volume may indicate that there is increased interest in the stock and that it may be experiencing a short-term price trend. Conversely, a stock that is trading below its 30-day average volume may indicate that there is less interest in the stock and that it may be experiencing a short-term price trend.
Additionally, the 1 month volume average indicator can also be used in combination with other technical indicators to gain a better understanding of market conditions. For example, if a stock’s price is rising and the 30-day average volume is also increasing, this can indicate that there is strong buying interest and that the upward trend in price is likely to continue. On the other hand, if a stock’s price is falling and the 30-day average volume is decreasing, this can indicate that there is weak selling interest and that the downward trend in price is likely to continue.
It’s important to note that the 1 month volume average indicator is a lagging indicator, meaning that it is based on past data and may not provide insight into future price movements. Traders and investors should use this indicator in combination with other technical and fundamental analysis tools in order to make informed investment decisions.
In conclusion, the 1 month volume average indicator, also known as the 30-day average volume, is a technical indicator
Open interest in options trading refers to the total number of options contracts that have been traded on a particular underlying asset but have not yet been closed or exercised. It is a measure of the level of activity in the options market for a particular underlying asset and can provide valuable information about market sentiment and the level of interest in that asset.
Open interest is different from trading volume, which measures the number of options contracts that have been traded on a particular underlying asset during a specific period of time. While trading volume can fluctuate from day to day, open interest reflects the total number of outstanding options contracts at any given time.
Open interest can be used in combination with other indicators, such as trading volume and price movements, to gain a better understanding of market conditions. A high open interest for a particular underlying asset may indicate that there is a large number of traders who are interested in that asset, which can make it more likely that the asset’s price will be affected by the activity in the options market.
Traders also use open interest to track the activity of large institutional traders such as hedge funds and investment banks. These traders often trade in large sizes, and changes in their open interest can have a significant impact on the market. By monitoring open interest, traders can get an insight into how institutional traders are positioning themselves in the market, which can provide valuable information for trading decisions.
Open interest can be used in several ways, such as by comparing it with trading volume, by using it as an input in options pricing models, and using it to identify trading patterns. It can also be used to confirm or refute the current market assumptions, for instance, an increase in open interest on a particular strike price of an option means that there is a high interest on that strike.
In conclusion, open interest in options trading refers to the total number of options contracts that have been traded on a particular underlying asset but have not yet been closed or exercised. It is a measure of the level of activity in the options market for a particular underlying asset and can provide valuable information about market sentiment and the level of interest in that asset. Open interest can be used in combination with other indicators, such as trading volume and price movements, to gain a better understanding
NOTE IN OUT CASE THE RATIO IS INVERSE AT THIS DESCRIPTION WE HAVE REALIZED VOLATILITY/ IMPLIED
With equity markets currently in melt-up mode and the VIX dragging near historical lows, there haven’t been a myriad of great opportunities to sell options premium.
However, while the VIX may not be flashing “sell” when it comes to short volatility, options traders have the ability to filter for potential opportunities using another tactic—namely, the spread that exists between implied volatility and realized volatility (aka actual volatility).
As most traders already know, implied volatility represents the current market price for volatility based on the market’s expectations for future movement in a given underlying. This value is “implied” by the dollar and cent value of options trading in the marketplace.
Realized volatility, on the other hand, is the actual movement that occurs in a given underlying over a defined historical period of time. Volatility traders obviously care not only about what is expected to occur, but also about what actually transpired.
For this reason, options traders often leverage the spread that exists between implied volatility (IV) and realized volatility (RV) to better gauge the relative attractiveness of a given trading opportunity.
A positive IV-RV spread indicates that implied volatility is higher than realized volatility, while a negative spread indicates the reverse. As one can see in the graphic below, historical data in SPY clearly illustrates that the bias in the IV-RV spread has been consistently positive. It’s this reality that underpins the value proposition of the short premium approach in the options marketplace:
While the above is great information to be aware of, previous research conducted by the tastytrade financial network takes the practical application of the IV-RV spread one step further.
Using a series of backtests, market researchers at tastytrade looked at historical data in SPY to ascertain the performance of short strangles deployed in SPY across a range of different widths in the IV-RV spread.
As one might suspect, the findings from this research revealed that short premium approaches tend to outperform when the spread between IV and RV are at the wider end of the range, as illustrated below:
Per the findings above, short strangles in SPY have performed more efficiently (higher win rates and higher profit targets) when deployed according to a trading approach that capitalizes on wider widths in the spread between implied volatility and realized volatility.
Due to the importance of these findings, traders are encouraged to review the complete episode of Ryan & Beeffocusing on the historical spread between IV and RV when scheduling allows.
As a complement to that information, traders may want to watch a new installment of Options Jiveon the tastytrade network that focuses on current potential opportunities in both equities and futures options where the spread between IV and RV is currently the widest.
While the current low volatility environment may not compel traders to take a high degree of short volatility risk, the aforementioned approach leveraging the IV-RV spread can also be utilized in high volatility trading environments to provide additional insight on potential opportunities.
Margin of safety is a principle used by investors to reduce the risk of losing money when investing in stocks, bonds, or other securities. The margin of safety is the difference between the intrinsic value of an asset and its market price, and it is used as a measure of how undervalued or overvalued an asset is.
The idea behind margin of safety is that it allows investors to buy an asset at a price that is below its intrinsic value, providing a cushion against future market downturns. By purchasing an asset at a significant discount to its intrinsic value, investors are able to limit their potential losses and increase their chances of earning a profitable return.
One famous investor who heavily used the principle of margin of safety was Benjamin Graham, who is considered the father of value investing. He proposed that investors should only buy stocks when they are available at a discount of at least 50% to their intrinsic value to ensure they have an adequate margin of safety.
One way to estimate intrinsic value is by using a company’s financial metrics, such as price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, and dividends per share, and compare them to historical averages and industry averages.
Another way to estimate intrinsic value is through the use of discounted cash flow (DCF) models. DCF models take into account a company’s projected cash flows, growth rate, and discount rate to estimate its intrinsic value.
It’s important to note that the intrinsic value is often difficult to estimate, and different methods and calculations can lead to different results. Additionally, the margin of safety doesn’t guarantee success, and it’s important to evaluate other information such as a company’s future growth prospects, management and industry trends before making any investments decisions.
In conclusion, the margin of safety is a principle used by investors to reduce the risk of losing money when investing in stocks, bonds, or other securities by buying at a price that is below its intrinsic value. By purchasing an asset at a significant discount to its intrinsic value, investors are able to limit their potential losses and increase their chances of earning a profitable return. The margin of safety can be estimated through financial metrics and discounted cash flow models, but it’s important to note that the intrinsic value is often difficult to estimate, and it
The difference between the actual average EPS estimation and the estimation made 7 days ago
Whit this particular tool we want know if the EPS estimation of current year if is change and how much it in the last 7 Days
An earnings estimate is an analyst’s estimate for a company’s future quarterly or annual earnings per share (EPS). Future earnings estimates are arguably the most important input when attempting to value a firm. By placing estimates on the earnings of a firm for certain periods (quarterly, annually, etc.), analysts can then use cash flow analysis to approximate fair value for a company, which in turn will give a target share price.
Investors often rely on earnings estimates to analyze different stocks and decide whether to buy or sell them.
An earnings estimate is an analyst’s forecast for a public company’s future quarterly or annual earnings per share (EPS).
Investors rely heavily on earnings estimates to gauge a company’s performance and make investment decisions about it.
Most investors use a consensus earnings estimate, a forecast of a public company’s projected earnings based on the combined estimates of all equity analysts that cover the stock.
Whether a company meets, beats, or misses its earnings estimates can impact the price of the underlying stock, particularly in the short term.
Earnings surprises occur when a company misses the consensus estimate either by earning more than expected or less.
Understanding an Earnings Estimate
Analysts use forecasting models, management guidance, and fundamental information on the company to derive an EPS estimate. Market participants rely heavily on earnings estimates to gauge a company’s performance. So whether a company meets, beats, or misses its earnings estimates can impact the price of the underlying stock, particularly in the short term.
Analysts’ earnings estimates are often aggregated to create consensus estimates. These are used as a benchmark against which the company’s performance is evaluated. When you hear that a company has “missed estimates” or “beaten estimates,” it’s usually in reference to consensus estimates.
A few companies, such as Refinitiv and Zacks Investment Research, compile estimates and compute the average or consensus. Their forecasts can be found in stock quotations or financial publications such as TheWall Street Journal. Consensus numbers can also be found at a number of financial websites such as Yahoo! Finance, Bloomberg, Visible Alpha, Morningstar.com, and Google Finance.
The difference between the actual average EPS estimation and the estimation made 30 days ago
Whit this particular tool we want know if the EPS estimation of current year if is change and how much it in the last 30 Days
An earnings estimate is an analyst’s estimate for a company’s future quarterly or annual earnings per share (EPS). Future earnings estimates are arguably the most important input when attempting to value a firm. By placing estimates on the earnings of a firm for certain periods (quarterly, annually, etc.), analysts can then use cash flow analysis to approximate fair value for a company, which in turn will give a target share price.
Investors often rely on earnings estimates to analyze different stocks and decide whether to buy or sell them.
An earnings estimate is an analyst’s forecast for a public company’s future quarterly or annual earnings per share (EPS).
Investors rely heavily on earnings estimates to gauge a company’s performance and make investment decisions about it.
Most investors use a consensus earnings estimate, a forecast of a public company’s projected earnings based on the combined estimates of all equity analysts that cover the stock.
Whether a company meets, beats, or misses its earnings estimates can impact the price of the underlying stock, particularly in the short term.
Earnings surprises occur when a company misses the consensus estimate either by earning more than expected or less.
Understanding an Earnings Estimate
Analysts use forecasting models, management guidance, and fundamental information on the company to derive an EPS estimate. Market participants rely heavily on earnings estimates to gauge a company’s performance. So whether a company meets, beats, or misses its earnings estimates can impact the price of the underlying stock, particularly in the short term.
Analysts’ earnings estimates are often aggregated to create consensus estimates. These are used as a benchmark against which the company’s performance is evaluated. When you hear that a company has “missed estimates” or “beaten estimates,” it’s usually in reference to consensus estimates.
A few companies, such as Refinitiv and Zacks Investment Research, compile estimates and compute the average or consensus. Their forecasts can be found in stock quotations or financial publications such as TheWall Street Journal. Consensus numbers can also be found at a number of financial websites such as Yahoo! Finance, Bloomberg, Visible Alpha, Morningstar.com, and Google Finance.
The difference between Average EPS Estimate Current Year and EPS of Last Fiscal Year
An earnings estimate is an analyst’s estimate for a company’s future quarterly or annual earnings per share (EPS). Future earnings estimates are arguably the most important input when attempting to value a firm. By placing estimates on the earnings of a firm for certain periods (quarterly, annually, etc.), analysts can then use cash flow analysis to approximate fair value for a company, which in turn will give a target share price.
Investors often rely on earnings estimates to analyze different stocks and decide whether to buy or sell them.
An earnings estimate is an analyst’s forecast for a public company’s future quarterly or annual earnings per share (EPS).
Investors rely heavily on earnings estimates to gauge a company’s performance and make investment decisions about it.
Most investors use a consensus earnings estimate, a forecast of a public company’s projected earnings based on the combined estimates of all equity analysts that cover the stock.
Whether a company meets, beats, or misses its earnings estimates can impact the price of the underlying stock, particularly in the short term.
Earnings surprises occur when a company misses the consensus estimate either by earning more than expected or less.
Understanding an Earnings Estimate
Analysts use forecasting models, management guidance, and fundamental information on the company to derive an EPS estimate. Market participants rely heavily on earnings estimates to gauge a company’s performance. So whether a company meets, beats, or misses its earnings estimates can impact the price of the underlying stock, particularly in the short term.
Analysts’ earnings estimates are often aggregated to create consensus estimates. These are used as a benchmark against which the company’s performance is evaluated. When you hear that a company has “missed estimates” or “beaten estimates,” it’s usually in reference to consensus estimates.
A few companies, such as Refinitiv and Zacks Investment Research, compile estimates and compute the average or consensus. Their forecasts can be found in stock quotations or financial publications such as TheWall Street Journal. Consensus numbers can also be found at a number of financial websites such as Yahoo! Finance, Bloomberg, Visible Alpha, Morningstar.com, and Google Finance.
The difference between the Average EPS Estimate Current Qtr and the Last QuarterEPS
An earnings estimate is an analyst’s estimate for a company’s future quarterly or annual earnings per share (EPS). Future earnings estimates are arguably the most important input when attempting to value a firm. By placing estimates on the earnings of a firm for certain periods (quarterly, annually, etc.), analysts can then use cash flow analysis to approximate fair value for a company, which in turn will give a target share price.
Investors often rely on earnings estimates to analyze different stocks and decide whether to buy or sell them.
An earnings estimate is an analyst’s forecast for a public company’s future quarterly or annual earnings per share (EPS).
Investors rely heavily on earnings estimates to gauge a company’s performance and make investment decisions about it.
Most investors use a consensus earnings estimate, a forecast of a public company’s projected earnings based on the combined estimates of all equity analysts that cover the stock.
Whether a company meets, beats, or misses its earnings estimates can impact the price of the underlying stock, particularly in the short term.
Earnings surprises occur when a company misses the consensus estimate either by earning more than expected or less.
Understanding an Earnings Estimate
Analysts use forecasting models, management guidance, and fundamental information on the company to derive an EPS estimate. Market participants rely heavily on earnings estimates to gauge a company’s performance. So whether a company meets, beats, or misses its earnings estimates can impact the price of the underlying stock, particularly in the short term.
Analysts’ earnings estimates are often aggregated to create consensus estimates. These are used as a benchmark against which the company’s performance is evaluated. When you hear that a company has “missed estimates” or “beaten estimates,” it’s usually in reference to consensus estimates.
A few companies, such as Refinitiv and Zacks Investment Research, compile estimates and compute the average or consensus. Their forecasts can be found in stock quotations or financial publications such as TheWall Street Journal. Consensus numbers can also be found at a number of financial websites such as Yahoo! Finance, Bloomberg, Visible Alpha, Morningstar.com, and Google Finance.
The difference between the Average EPS Estimate Next Quarter and the Average EPS Estimate Current Quarter
An earnings estimate is an analyst’s estimate for a company’s future quarterly or annual earnings per share (EPS). Future earnings estimates are arguably the most important input when attempting to value a firm. By placing estimates on the earnings of a firm for certain periods (quarterly, annually, etc.), analysts can then use cash flow analysis to approximate fair value for a company, which in turn will give a target share price.
Investors often rely on earnings estimates to analyze different stocks and decide whether to buy or sell them.
An earnings estimate is an analyst’s forecast for a public company’s future quarterly or annual earnings per share (EPS).
Investors rely heavily on earnings estimates to gauge a company’s performance and make investment decisions about it.
Most investors use a consensus earnings estimate, a forecast of a public company’s projected earnings based on the combined estimates of all equity analysts that cover the stock.
Whether a company meets, beats, or misses its earnings estimates can impact the price of the underlying stock, particularly in the short term.
Earnings surprises occur when a company misses the consensus estimate either by earning more than expected or less.
Understanding an Earnings Estimate
Analysts use forecasting models, management guidance, and fundamental information on the company to derive an EPS estimate. Market participants rely heavily on earnings estimates to gauge a company’s performance. So whether a company meets, beats, or misses its earnings estimates can impact the price of the underlying stock, particularly in the short term.
Analysts’ earnings estimates are often aggregated to create consensus estimates. These are used as a benchmark against which the company’s performance is evaluated. When you hear that a company has “missed estimates” or “beaten estimates,” it’s usually in reference to consensus estimates.
A few companies, such as Refinitiv and Zacks Investment Research, compile estimates and compute the average or consensus. Their forecasts can be found in stock quotations or financial publications such as TheWall Street Journal. Consensus numbers can also be found at a number of financial websites such as Yahoo! Finance, Bloomberg, Visible Alpha, Morningstar.com, and Google Finance.
A maximum drawdown (MDD) is the maximum observed loss from a peak to a trough of a portfolio, before a new peak is attained. Maximum drawdown is an indicator of downside risk over a specified time period.
It can be used both as a stand-alone measure or as an input into other metrics such as “Return over Maximum Drawdown” and the Calmar Ratio. Maximum Drawdown is expressed in percentage terms.
Maximum drawdown is a specific measure of drawdown that looks for the greatest movement from a high point to a low point, before a new peak is achieved. However, it’s important to note that it only measures the size of the largest loss, without taking into consideration the frequency of large losses. Because it measures only the largest drawdown, MDD does not indicate how long it took an investor to recover from the loss, or if the investment even recovered at all.
Maximum drawdown (MDD) is an indicator used to assess the relative riskiness of one stock screening strategy versus another, as it focuses on capital preservation, which is a key concern for most investors. For example, two screening strategies can have the same average outperformance, tracking error, and volatility, but their maximum drawdowns compared to the benchmark can be very different.
A low maximum drawdown is preferred as this indicates that losses from investment were small. If an investment never lost a penny, the maximum drawdown would be zero. The worst possible maximum drawdown would be -100%, meaning the investment is completely worthless.
MDD should be used in the right perspective to derive the maximum benefit from it. In this regard, particular attention should be paid to the time period being considered. For instance, a hypothetical long-only U.S. fund Gamma has been in existence since 2000 and had a maximum drawdown of -30% in the period ending 2010. While this may seem like a huge loss, note that the S&P 500 had plunged more than 55% from its peak in October 2007 to its trough in March 2009. While other metrics would need to be considered to assess Gamma fund’s overall performance, from the viewpoint of MDD, it has outperformed its benchmark by a huge margin.
This risk measure shows the largest peak to trough price drop in the past 5 years. Our calculations use closing prices adjusted for dividend payments.
What Is a Maximum Drawdown (MDD)?
Drawdown in stock trading refers to the peak-to-trough decline in the value of a stock portfolio or an individual stock from its highest point to its lowest point. In other words, it’s the amount by which an investment’s value falls from its peak before a rebound or a recovery. It is a measure of risk and is an important metric for investors to track as it provides insight into the potential for future losses and the level of risk associated with a particular stock or portfolio.
There are two types of drawdown: the maximum drawdown, which is the largest peak-to-trough decline in the value of the stock or portfolio, and the drawdown duration, which is the number of days it takes for an investment to recover from its maximum drawdown to a new high.
Investors use drawdown as an indicator of risk, and a higher drawdown indicates a higher level of risk, and a lower drawdown indicates a lower level of risk. This is because a higher drawdown means that the stock or portfolio has suffered greater losses and is more susceptible to price fluctuations.
It’s important to note that a drawdown is not a measure of the overall performance of a stock or portfolio, but rather a measure of the risk associated with that stock or portfolio. A stock or portfolio that experiences a high drawdown may have a higher return over time, while a stock or portfolio that experiences a low drawdown may have a lower return over time.
In conclusion, Drawdown in stock trading refers to the peak-to-trough decline in the value of a stock portfolio or an individual stock from its highest point to its lowest point. It’s an important metric for investors to track as it provides insight into the level of risk and the potential for future losses. It’s important to note that a drawdown is not a measure of the overall performance of a stock or portfolio, but rather a measure of the risk associated with that stock or portfolio. Investors use drawdown as an indicator of risk, a higher drawdown indicates a higher level of risk, and a lower drawdown indicates a lower level of risk.
The single-quarter earnings per share announced on the last earnings report date.
PS or earnings per share is a financial metric used to measure a company’s profitability. It is calculated by dividing a company’s net income by the number of outstanding shares of stock. EPS is used to evaluate a company’s performance, particularly in comparison to its competitors and industry averages.
EPS can be estimated using a variety of methods. One of the most common is through the use of financial analysts’ estimates, which are generated by financial analysts who track the company and provide predictions for future earnings. These estimates are usually based on a combination of historical financial data and the analyst’s own assumptions about future performance.
Another method for estimating EPS is through the use of financial models such as the discounted cash flow (DCF) model, which takes into account a company’s projected future cash flows, growth rate, and discount rate. The DCF model provides a present value of future cash flows, and by subtracting the company’s present value of debt and equity, we can estimate the company’s net income and then divide it by the number of outstanding shares to estimate EPS.
It’s important to note that EPS estimates are often subject to change and may not always be accurate. Factors such as economic conditions, industry trends, and company-specific events can affect a company’s performance and may cause actual EPS to differ from estimated EPS. Additionally, it’s important to consider other financial metrics, such as revenue and return on equity, to gain a better understanding of a company’s overall performance.
In conclusion, EPS or earnings per share is a financial metric used to measure a company’s profitability. It is calculated by dividing a company’s net income by the number of outstanding shares of stock. EPS can be estimated using a variety of methods such as financial analysts estimates and financial models such as DCF. However, it’s important to note that EPS estimates are often subject to change and may not always be accurate, Factors such as economic conditions, industry trends, and company-specific events can affect a company’s performance. Additionally, it’s important to consider other financial metrics to gain a better understanding of a company’s overall performance.
The average sales estimate for the current quarter.
The average sales estimate is a financial metric used to forecast a company’s future revenue. It is typically calculated by taking the average of revenue forecasts made by a group of analysts who cover the company. These analysts may be employed by investment banks, research firms, or other financial institutions.
Average sales estimates are important for investors and traders as they provide an idea of what to expect from a company’s revenue in the future. They can be used to evaluate a company’s performance and to compare it to its peers and industry averages.
Analysts typically use a variety of methods to estimate a company’s sales, such as analyzing historical financial data, industry trends, and the company’s own guidance. They also may consider external factors such as economic conditions and competition.
It’s important to note that the average sales estimate is just that, an estimate, and actual sales figures may differ from the estimates. Additionally, analysts have varying degrees of accuracy, and the range of estimates can be wide. Therefore, investors should use average sales estimates as one of several inputs when making investment decisions and should always conduct their own due diligence.
In conclusion, the average sales estimate is a financial metric used to forecast a company’s future revenue. It’s typically calculated by taking the average of revenue forecasts made by a group of analysts who cover the company. These estimates can be used to evaluate a company’s performance and compare it to its peers and industry averages. However, it’s important to note that the average sales estimate is just an estimate and actual sales figures may differ from the estimates. Investors should use average sales estimates as one of several inputs when making investment decisions and should always conduct their own due diligence.
The average sales estimate is a financial metric used to forecast a company’s future revenue. It is typically calculated by taking the average of revenue forecasts made by a group of analysts who cover the company. These analysts may be employed by investment banks, research firms, or other financial institutions.
Average sales estimates are important for investors and traders as they provide an idea of what to expect from a company’s revenue in the future. They can be used to evaluate a company’s performance and to compare it to its peers and industry averages.
Analysts typically use a variety of methods to estimate a company’s sales, such as analyzing historical financial data, industry trends, and the company’s own guidance. They also may consider external factors such as economic conditions and competition.
It’s important to note that the average sales estimate is just that, an estimate, and actual sales figures may differ from the estimates. Additionally, analysts have varying degrees of accuracy, and the range of estimates can be wide. Therefore, investors should use average sales estimates as one of several inputs when making investment decisions and should always conduct their own due diligence.
In conclusion, the average sales estimate is a financial metric used to forecast a company’s future revenue. It’s typically calculated by taking the average of revenue forecasts made by a group of analysts who cover the company. These estimates can be used to evaluate a company’s performance and compare it to its peers and industry averages. However, it’s important to note that the average sales estimate is just an estimate and actual sales figures may differ from the estimates. Investors should use average sales estimates as one of several inputs when making investment decisions and should always conduct their own due diligence.
The 5-year high and low price compared to the current price
Calculate the current price in which range is between the minimum and maximum price touched by a stock in the last 5 years, where 100 is the maximum and 1 is the minimum. For example if the stock has had a maximum price of 1000$ and a minimum of 500$ in the last 5 years and the current price is 750$ it means that we are at 50% of the price range.
Forward analyst estimated forward EBIT for the next fiscal year and the last EBIT
EBIT is the acronym for earnings before interest and taxes. This income statement line relates to the profitability of a company’s business. EBIT may also be referred to as profit before interest and taxes. It is often conflated with Operating Income but has some key differences that we’ll review.
What EBIT Is
Business owners and investors frequently pay attention to EBIT, which is a company’s earnings before interest and taxes. EBIT appears on a company’s income statement, and its measurement assists business owners and investors in assessing profitability. EBIT answers the question of how much of a company’s revenues remain after operating expenses are deducted.
If a company’s EBIT is negative, the managers will either have to curb expenses or increase revenues to have a chance at becoming profitable.
EBIT Formula and Calculation
The EBIT formula subtracts the cost of goods sold (COGS) and operating expenses from the gross revenue. The formula looks like this:
EBIT = Gross Revenue – COGS – Operating Expenses
Cost of Goods Sold is found on the income statement just below revenues. There may be multiple lines that make up the COGS section and could include materials and labor costs. The operating expenses will be the next section and include overhead such as rent, equipment leasing, marketing, insurance, and research and development.
For example, ACME Widget Store spends $1 to create a widget. They make 1 million widgets in a quarter, but sell 800,000 of those widgets for a price of $2 per widget. Gross revenues are thus $1,600,000, while COGS for the quarter is reported as $800,000. On top of the COGS, they spend $12,000 per quarter in rent, $20,000 per quarter in sales and marketing, $3,000 per quarter on insurance, and $5,000 in equipment leasing. Adding these costs together means that the company has $40,000 in operating expenses for the quarter.
To determine the quarterly EBIT of ACME Widget Store, subtract the COGS and operating expenses from the gross revenue (EBIT = $1,600,000 – $800,000 – $40,000 = $760,000).
How EBIT Is Used
EBIT is a measure of a business’ operational profitability. It excludes taxes and interest so that the measure focuses solely on earnings from business operations. EBIT levels are dependent on volume of sales, product pricing, and cost efficiency.
EBIT isn’t only used internally to determine profitability. It is often used in conjunction with Enterprise Value (EV) by investors and analysts to assess a company’s relative value. Some investors are interested in how much EBIT a company generates in relation to its Enterprise Value. The EV is the market capitalization of the company plus net debt (debt – cash). If EV/EBIT ratio is low, a company may be considered undervalued (on this metric), and vice versa.
Important: Using EV/EBIT ratios, investors can compare the valuations of companies without regard to tax bracket or corporate structures.
For example, let’s look at two hypothetical company valuations:
Company A:
EBIT of $2.5 million
Market capitalization of $20 million
$5 million in debt
$1 million in cash
Company B:
EBIT of $1.1 million
Market capitalization of $10 million
$6 million in debt
$0.5 million in cash
This means that Company A has an EV of $24 million while Company B has an EV of $15.5 million. Running the ratios:
Company A: $24 million / $2.5 million = 9.6x
Company B: $15.5 million / $1.1 million = 14.1x
On an EV/EBIT basis alone, Company A looks like it offers better value than Company B.
EBIT Limitations
Investors should be careful about using EBIT or EV/EBIT ratios in isolation to determine a company’s financial health and valuation appeal. While it gives good insight into the profitability of a firm’s business operations, it doesn’t take into consideration the company’s capital structure. For instance, even if a company reports strong EBIT numbers, if a company is highly leveraged, it may not be profitable at all once interest is deducted.
Warning: EBIT and EV/EBIT values shouldn’t be used in isolation in assessing a company.
EBIT Alternatives
An investor or business owner can look at some alternative measures to EBIT which may end up providing a different picture of the financial health of the company. Here are some EBIT alternatives and how they compare.
Earnings before interest, taxes, depreciation, and amortization is essentially net income with these things added back to it. It is used to analyze and compare profitability without the effects of finance and accounting decisions.
What Is EBITDA?
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an alternate measure of profitability to net income. By stripping out the non-cash depreciation and amortization expense as well as taxes and debt costs dependent on the capital structure, EBITDA attempts to represent cash profit generated by the company’s operations.
EBITDA is not a metric recognized under generally accepted accounting principles (GAAP). Some public companies report EBITDA in their quarterly results along with adjusted EBITDA figures typically excluding additional costs, such as stock-based compensation.
Increased focus on EBITDA by companies and investors has prompted claims that it overstates profitability. The U.S. Securities and Exchange Commission (SEC) requires listed companies reporting EBITDA figures to show how they were derived from net income, and it bars them from reporting EBITDA on a per-share basis.1
KEY TAKEAWAYS
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a widely used measure of core corporate profitability.
EBITDA is calculated by adding interest, tax, depreciation, and amortization expenses to net income.
EBITDA lets investors assess corporate profitability net of expenses dependent on financing decisions, tax strategy, and discretionary depreciation schedules.
Some, including Warren Buffett, call EBITDA meaningless because it omits capital costs.
The U.S. Securities and Exchange Commission (SEC) requires listed companies to reconcile any EBITDA figures they report with net income and bars them from reporting EBITDA per share.
EBITDA
EBITDA Formulas and Calculation
If a company doesn’t report EBITDA, it can be easily calculated from its financial statements.
The earnings (net income), tax, and interest figures are found on the income statement, while the depreciation and amortization figures are normally found in the notes to operating profit or on the cash flow statement. The usual shortcut for calculating EBITDA is to start with operating profit, also called earnings before interest and taxes (EBIT), then add back depreciation and amortization.
There are two distinct EBITDA formulas, one based on net income and the other on operating income. The respective EBITDA formulas are:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization
and
EBITDA = Operating Income + Depreciation & Amortization
Understanding EBITDA
EBITDA is net income (earnings) with interest, taxes, depreciation, and amortization added back. EBITDA can be used to track and compare the underlying profitability of companies regardless of their depreciation assumptions or financing choices.
Like earnings, EBITDA is often used in valuation ratios, notably in combination with enterprise value as EV/EBITDA, also known as the enterprise multiple.
EBITDA is especially widely used in the analysis of asset-intensive industries with a lot of property, plant, and equipment and correspondingly high non-cash depreciation costs. In those sectors, the costs that EBITDA excludes may obscure changes in the underlying profitability—for example, as for energy pipelines.
Meanwhile, amortization is often used to expense the cost of software development or other intellectual property. That’s one reason why early-stage technology and research companies use EBITDA when discussing their performance.2
Annual changes in tax liabilities and assets that must be reflected on the income statement may not relate to operational performance. Interest costs depend on debt levels, interest rates, and management preferences regarding debt vs. equity financing. Excluding all these items keeps the focus on the cash profits generated by the company’s business.
Of course, not everyone agrees. “References to EBITDA make us shudder,” Berkshire Hathaway Inc. (BRK.A) CEO Warren Buffett has written. According to Buffett, depreciation is a real cost that can’t be ignored and EBITDA is not “a meaningful measure of performance.”3
Example of EBITDA
A company generates $100 million in revenue and incurs $40 million in cost of goods sold and another $20 million in overhead. Depreciation and amortization expenses total $10 million, yielding an operating profit of $30 million. Interest expense is $5 million, leaving earnings before taxes of $25 million. With a 20% tax rate and interest expense tax deductible, net income equals $21 million after $4 million in taxes is subtracted from pretax income. If depreciation, amortization, interest, and taxes are added back to net income, EBITDA equals $40 million.
Net Income
$21,000,000
Depreciation Amortization
+$10,000,000
Interest Expense
+$5,000,000
Taxes
+$4,000,000
EBITDA
$40,000,000
History of EBITDA
EBITDA is the invention of one of the very few investors with a record rivaling Buffett’s: Liberty Media Chair John Malone.4 The cable industry pioneer came up with the metric in the 1970s to help sell lenders and investors on his leveraged growth strategy, which deployed debt and reinvested profits to minimize taxes.56
During the 1980s, the investors and lenders involved in leveraged buyouts (LBOs) found EBITDA useful in estimating whether the targeted companies had the profitability to service the debt likely to be incurred in the acquisition. Since a buyout would likely entail a change in the capital structure and tax liabilities, it made sense to exclude the interest and tax expense from earnings. As non-cash costs, depreciation and amortization expense would not affect the company’s ability to service that debt, at least in the near term.7
The LBO buyers tended to target companies with minimal or modest near-term capital spending plans, while their own need to secure financing for the acquisitions led them to focus on the EBITDA-to-interest coverage ratio, which weighs core operating profitability as represented by EBITDA against debt service costs.7
EBITDA gained notoriety during the dotcom bubble, when some companies used it to exaggerate their financial performance.8
The metric received more bad publicity in 2018 after WeWork Companies Inc., a provider of shared office space, filed a prospectus for its initial public offering (IPO) defining its “Community Adjusted EBITDA” as excluding general and administrative as well as sales and marketing expenses.910
Drawbacks of EBITDA
Because EBITDA is a non-GAAP measure, the way it is calculated can vary from one company to the next. It is not uncommon for companies to emphasize EBITDA over net income because the former makes them look better.
An important red flag for investors is when a company that hasn’t reported EBITDA in the past starts to feature it prominently in results. This can happen when companies have borrowed heavily or are experiencing rising capital and development costs. In those cases, EBITDA may serve to distract investors from the company’s challenges.
Ignores Costs of Assets
A common misconception is that EBITDA represents cash earnings. However, unlike free cash flow, EBITDA ignores the cost of assets. One of the most common criticisms of EBITDA is that it assumes profitability is a function of sales and operations alone—almost as if the company’s assets and debt financing were a gift. To quote Buffett again, “Does management think the tooth fairy pays for capital expenditures?”11
What Defines Earnings?
While subtracting interest payments, tax charges, depreciation, and amortization from earnings may seem simple enough, different companies use different earnings figures as the starting point for EBITDA. In other words, EBITDA is susceptible to the earnings accounting games found on the income statement. Even if we account for the distortions that result from excluding interest, taxation, depreciation, and amortization costs, the earnings figure in EBITDA may still prove unreliable.
Obscures Company Valuation
All the cost exclusions in EBITDA can make a company look much less expensive than it really is. When analysts look at stock price multiples of EBITDA rather than at bottom-line earnings, they produce lower multiples.
Consider the historical example of wireless telecom operator Sprint Nextel. On April 1, 2006, the stock was trading at 7.3 times its forecast EBITDA. That might sound like a low multiple, but it doesn’t mean that the company is a bargain. As a multiple of forecast operating profits, Sprint Nextel traded at a much-higher 20 times. The company traded at 48 times its estimated net income.
“There’s been some real sloppiness in accounting, and this move toward using adjusted EBITDA and adjusted earnings has produced some companies that I think are trading on valuations that are not supported by the real numbers,” hedge fund manager Daniel Loeb said in 2015.12
Not much has changed on that front since then. Investors using solely EBITDA to assess a company’s value or results risk getting the wrong answer.
EBITDA vs. EBT and EBIT
Earnings before interest and taxes (EBIT), as mentioned earlier, is a company’s net income excluding income tax expense and interest expense. EBIT is used to analyze the profitability of a company’s core operations. The following formula is used to calculate EBIT:
Since net income includes interest and tax expenses, to calculate EBIT, these deductions from net income must be reversed. EBIT is often mistaken for operating income since both exclude tax and interest costs. However, EBIT may include nonoperating income while operating income does not.
Earnings before tax (EBT) reflects how much of an operating profit has been realized before accounting for taxes, while EBIT excludes both taxes and interest payments. EBT is calculated by adding tax expense to the company’s net income.
By excluding tax liabilities, investors can use EBT to evaluate performance after eliminating a variable typically not within the company’s control. In the United States, this is most useful for comparing companies that might be subject to different state rates of federal tax rules.
EBT and EBIT do include the non-cash expenses of depreciation and amortization, which EBITDA leaves out.
EBITDA vs. Operating Cash Flow
Operating cash flow is a better measure of how much cash a company is generating because it adds non-cash charges (depreciation and amortization) back to net income but also includes changes in working capital, including receivables, payables, and inventory, that use or provide cash.
Working capital trends are an important consideration in determining how much cash a company is generating. If investors don’t include working capital changes in their analysis and rely solely on EBITDA, they may miss clues—for example, such as difficulties with receivables collection—that may impair cash flow.
How do you calculate earnings before interest, taxes, depreciation, and amortization (EBITDA)?
You can calculate earnings before interest, taxes, depreciation, and amortization (EBITDA) by using the information from a company’s income statement, cash flow statement, and balance sheet. The formula is as follows:
EBITDA = Net Income + Interest + Taxes + Depreciation & Amortization
What is a good EBITDA?
EBITDA is a measure of a company’s profitability, so higher is generally better. From an investor’s point of view, a “good” EBITDA is one that provides additional perspective on a company’s performance without making anyone forget that the metric excludes cash outlays for interest and taxes as well as the eventual cost of replacing its tangible assets.
What is amortization in EBITDA?
As it relates to EBITDA, amortization is the gradual discounting of the book value of a company’s intangible assets. Amortization is reported on a company’s income statement. Intangible assets include intellectual property such as patents or trademarks as well as goodwill, the difference between the cost of past acquisitions and their fair market value when purchased.
The Bottom Line
EBITDA is a useful tool for comparing companies subject to disparate tax treatments and capital costs, or analyzing them in situations where these are likely to change. It also omits non-cash depreciation costs that may not accurately represent future capital spending requirements. At the same time, excluding some costs while including others has opened the door to the metric’s abuse by unscrupulous corporate managers. The best defense against such practices is to read the fine print reconciling the reported EBITDA to net income.
analyst estimated forward EBITDA for the next fiscal year.
What Is EBITDA?
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an alternate measure of profitability to net income. By stripping out the non-cash depreciation and amortization expense as well as taxes and debt costs dependent on the capital structure, EBITDA attempts to represent cash profit generated by the company’s operations.
EBITDA is not a metric recognized under generally accepted accounting principles (GAAP). Some public companies report EBITDA in their quarterly results along with adjusted EBITDA figures typically excluding additional costs, such as stock-based compensation.
Increased focus on EBITDA by companies and investors has prompted claims that it overstates profitability. The U.S. Securities and Exchange Commission (SEC) requires listed companies reporting EBITDA figures to show how they were derived from net income, and it bars them from reporting EBITDA on a per-share basis.1
KEY TAKEAWAYS
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a widely used measure of core corporate profitability.
EBITDA is calculated by adding interest, tax, depreciation, and amortization expenses to net income.
EBITDA lets investors assess corporate profitability net of expenses dependent on financing decisions, tax strategy, and discretionary depreciation schedules.
Some, including Warren Buffett, call EBITDA meaningless because it omits capital costs.
The U.S. Securities and Exchange Commission (SEC) requires listed companies to reconcile any EBITDA figures they report with net income and bars them from reporting EBITDA per share.
EBITDA
EBITDA Formulas and Calculation
If a company doesn’t report EBITDA, it can be easily calculated from its financial statements.
The earnings (net income), tax, and interest figures are found on the income statement, while the depreciation and amortization figures are normally found in the notes to operating profit or on the cash flow statement. The usual shortcut for calculating EBITDA is to start with operating profit, also called earnings before interest and taxes (EBIT), then add back depreciation and amortization.
There are two distinct EBITDA formulas, one based on net income and the other on operating income. The respective EBITDA formulas are:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization
and
EBITDA = Operating Income + Depreciation & Amortization
Understanding EBITDA
EBITDA is net income (earnings) with interest, taxes, depreciation, and amortization added back. EBITDA can be used to track and compare the underlying profitability of companies regardless of their depreciation assumptions or financing choices.
Like earnings, EBITDA is often used in valuation ratios, notably in combination with enterprise value as EV/EBITDA, also known as the enterprise multiple.
EBITDA is especially widely used in the analysis of asset-intensive industries with a lot of property, plant, and equipment and correspondingly high non-cash depreciation costs. In those sectors, the costs that EBITDA excludes may obscure changes in the underlying profitability—for example, as for energy pipelines.
Meanwhile, amortization is often used to expense the cost of software development or other intellectual property. That’s one reason why early-stage technology and research companies use EBITDA when discussing their performance.2
Annual changes in tax liabilities and assets that must be reflected on the income statement may not relate to operational performance. Interest costs depend on debt levels, interest rates, and management preferences regarding debt vs. equity financing. Excluding all these items keeps the focus on the cash profits generated by the company’s business.
Of course, not everyone agrees. “References to EBITDA make us shudder,” Berkshire Hathaway Inc. (BRK.A) CEO Warren Buffett has written. According to Buffett, depreciation is a real cost that can’t be ignored and EBITDA is not “a meaningful measure of performance.”3
Example of EBITDA
A company generates $100 million in revenue and incurs $40 million in cost of goods sold and another $20 million in overhead. Depreciation and amortization expenses total $10 million, yielding an operating profit of $30 million. Interest expense is $5 million, leaving earnings before taxes of $25 million. With a 20% tax rate and interest expense tax deductible, net income equals $21 million after $4 million in taxes is subtracted from pretax income. If depreciation, amortization, interest, and taxes are added back to net income, EBITDA equals $40 million.
Net Income
$21,000,000
Depreciation Amortization
+$10,000,000
Interest Expense
+$5,000,000
Taxes
+$4,000,000
EBITDA
$40,000,000
History of EBITDA
EBITDA is the invention of one of the very few investors with a record rivaling Buffett’s: Liberty Media Chair John Malone.4 The cable industry pioneer came up with the metric in the 1970s to help sell lenders and investors on his leveraged growth strategy, which deployed debt and reinvested profits to minimize taxes.56
During the 1980s, the investors and lenders involved in leveraged buyouts (LBOs) found EBITDA useful in estimating whether the targeted companies had the profitability to service the debt likely to be incurred in the acquisition. Since a buyout would likely entail a change in the capital structure and tax liabilities, it made sense to exclude the interest and tax expense from earnings. As non-cash costs, depreciation and amortization expense would not affect the company’s ability to service that debt, at least in the near term.7
The LBO buyers tended to target companies with minimal or modest near-term capital spending plans, while their own need to secure financing for the acquisitions led them to focus on the EBITDA-to-interest coverage ratio, which weighs core operating profitability as represented by EBITDA against debt service costs.7
EBITDA gained notoriety during the dotcom bubble, when some companies used it to exaggerate their financial performance.8
The metric received more bad publicity in 2018 after WeWork Companies Inc., a provider of shared office space, filed a prospectus for its initial public offering (IPO) defining its “Community Adjusted EBITDA” as excluding general and administrative as well as sales and marketing expenses.910
Drawbacks of EBITDA
Because EBITDA is a non-GAAP measure, the way it is calculated can vary from one company to the next. It is not uncommon for companies to emphasize EBITDA over net income because the former makes them look better.
An important red flag for investors is when a company that hasn’t reported EBITDA in the past starts to feature it prominently in results. This can happen when companies have borrowed heavily or are experiencing rising capital and development costs. In those cases, EBITDA may serve to distract investors from the company’s challenges.
Ignores Costs of Assets
A common misconception is that EBITDA represents cash earnings. However, unlike free cash flow, EBITDA ignores the cost of assets. One of the most common criticisms of EBITDA is that it assumes profitability is a function of sales and operations alone—almost as if the company’s assets and debt financing were a gift. To quote Buffett again, “Does management think the tooth fairy pays for capital expenditures?”11
What Defines Earnings?
While subtracting interest payments, tax charges, depreciation, and amortization from earnings may seem simple enough, different companies use different earnings figures as the starting point for EBITDA. In other words, EBITDA is susceptible to the earnings accounting games found on the income statement. Even if we account for the distortions that result from excluding interest, taxation, depreciation, and amortization costs, the earnings figure in EBITDA may still prove unreliable.
Obscures Company Valuation
All the cost exclusions in EBITDA can make a company look much less expensive than it really is. When analysts look at stock price multiples of EBITDA rather than at bottom-line earnings, they produce lower multiples.
Consider the historical example of wireless telecom operator Sprint Nextel. On April 1, 2006, the stock was trading at 7.3 times its forecast EBITDA. That might sound like a low multiple, but it doesn’t mean that the company is a bargain. As a multiple of forecast operating profits, Sprint Nextel traded at a much-higher 20 times. The company traded at 48 times its estimated net income.
“There’s been some real sloppiness in accounting, and this move toward using adjusted EBITDA and adjusted earnings has produced some companies that I think are trading on valuations that are not supported by the real numbers,” hedge fund manager Daniel Loeb said in 2015.12
Not much has changed on that front since then. Investors using solely EBITDA to assess a company’s value or results risk getting the wrong answer.
EBITDA vs. EBT and EBIT
Earnings before interest and taxes (EBIT), as mentioned earlier, is a company’s net income excluding income tax expense and interest expense. EBIT is used to analyze the profitability of a company’s core operations. The following formula is used to calculate EBIT:
Since net income includes interest and tax expenses, to calculate EBIT, these deductions from net income must be reversed. EBIT is often mistaken for operating income since both exclude tax and interest costs. However, EBIT may include nonoperating income while operating income does not.
Earnings before tax (EBT) reflects how much of an operating profit has been realized before accounting for taxes, while EBIT excludes both taxes and interest payments. EBT is calculated by adding tax expense to the company’s net income.
By excluding tax liabilities, investors can use EBT to evaluate performance after eliminating a variable typically not within the company’s control. In the United States, this is most useful for comparing companies that might be subject to different state rates of federal tax rules.
EBT and EBIT do include the non-cash expenses of depreciation and amortization, which EBITDA leaves out.
EBITDA vs. Operating Cash Flow
Operating cash flow is a better measure of how much cash a company is generating because it adds non-cash charges (depreciation and amortization) back to net income but also includes changes in working capital, including receivables, payables, and inventory, that use or provide cash.
Working capital trends are an important consideration in determining how much cash a company is generating. If investors don’t include working capital changes in their analysis and rely solely on EBITDA, they may miss clues—for example, such as difficulties with receivables collection—that may impair cash flow.
How do you calculate earnings before interest, taxes, depreciation, and amortization (EBITDA)?
You can calculate earnings before interest, taxes, depreciation, and amortization (EBITDA) by using the information from a company’s income statement, cash flow statement, and balance sheet. The formula is as follows:
EBITDA = Net Income + Interest + Taxes + Depreciation & Amortization
What is a good EBITDA?
EBITDA is a measure of a company’s profitability, so higher is generally better. From an investor’s point of view, a “good” EBITDA is one that provides additional perspective on a company’s performance without making anyone forget that the metric excludes cash outlays for interest and taxes as well as the eventual cost of replacing its tangible assets.
What is amortization in EBITDA?
As it relates to EBITDA, amortization is the gradual discounting of the book value of a company’s intangible assets. Amortization is reported on a company’s income statement. Intangible assets include intellectual property such as patents or trademarks as well as goodwill, the difference between the cost of past acquisitions and their fair market value when purchased.
The Bottom Line
EBITDA is a useful tool for comparing companies subject to disparate tax treatments and capital costs, or analyzing them in situations where these are likely to change. It also omits non-cash depreciation costs that may not accurately represent future capital spending requirements. At the same time, excluding some costs while including others has opened the door to the metric’s abuse by unscrupulous corporate managers. The best defense against such practices is to read the fine print reconciling the reported EBITDA to net income.
We compute the Fair Value of a company by using a discounted cash flow analysis to determine the Intrinsic Value. We then rank firms in each Sector by their Intrinsic Value to find a value that is well suited to current market multiples. Over the long term our Fair Values will imply a 30% drop in price for the worst stocks and a 45% gain for the best stocks.
What Is Fair Value?
Fair value is the estimated price at which an asset is bought or sold when both the buyer and seller freely agree on a price.
To determine the fair value of a product or financial investment, an individual or business may look at actual market transactions for similar assets, estimate the expected earnings of the asset, and determine the cost to replace the asset.
KEY TAKEAWAYS
Fair value is the estimated price at which an asset is bought or sold when both the buyer and seller freely agree on a price.
Individuals and businesses may compare current market value, growth potential, and replacement cost to determine the fair value of an asset.
Fair value is a measure of an asset’s worth and market value is the price of an asset in the marketplace.
Fair value accounting is the practice of measuring a business’s liabilities and assets at their current market value.
1:40
Fair Value
Understanding Fair Value
Fair Value in Investing
A common way to determine a stock’s fair value is to list it on a publicly-traded stock exchange. As shares trade, investor demand creates the appropriate bid and ask prices, or market value, and influences an investor’s fair value estimate.
An investor can compare their fair value estimate with the market value to decide to buy or sell. The fair value is often the price that an investor pays that will generate their desired growth and rate of return.1
If the fair value of a stock share is $100, and the market price is $95, an investor may consider the stock undervalued and buy the stock. If the market price is $120, the investor will likely forego the purchase as the market value does not align with their idea of fair value.2
The fair value of a derivative is determined by the value of an underlying asset. When an investor buys a 50 call option, they are buying the right to purchase 100 shares of stock at $50 per share for a specific period. If the stock’s market price increases, the value of the option on the stock also increases.
In the futures market, fair value is the equilibrium price for a futures contract or the point where the supply of goods matches demand. This is equal to the spot price and accounts for compounded interest and lost dividends resulting from the futures contract ownership versus a physical stock purchase.
Fair Value of Stock Index Futures
\begin{aligned}&\text{Fair Value} = \text{Cash} \times \Big ( 1 + r \times \big ( \frac{ x }{ 360 } \big ) \Big ) – \text{Dividends} \\&\textbf{where:} \\&\text{Cash} = \text{Current value of security} \\&r = \text{Interest rate charged by broker} \\&x = \text{Number of days remaining in contract} \\&\text{Dividends} = \text{Number of dividends investor would} \\&\text{receive before expiration date} \\\end{aligned}Fair Value=Cash×(1+r×(360x))−Dividendswhere:Cash=Current value of securityr=Interest rate charged by brokerx=Number of days remaining in contractDividends=Number of dividends investor wouldreceive before expiration date
Fair Value in Accounting
The International Accounting Standards Board recognizes the fair value of certain assets and liabilities as the price at which an asset can be sold or a liability settled. Fair value accounting, or mark-to-market accounting, is the practice of calculating the value of a company’s assets and liabilities based on the current market value.
If a construction business acquired a truck worth $20,000 in 2019 and decided to sell the truck in 2022, comparable sale listings of the same used truck may include two trucks priced at $12,000 and $14,000. The estimated fair value of the truck may be determined as the average current market value, or $13,000.
It is difficult to determine a fair value for an asset if there is not an active market for it. Accountants will use discounted cash flows will determine a fair value by determining the cash outflow to purchase the equipment and the cash inflows generated by using the equipment over its useful life.
Fair value is also used in a consolidation when a subsidiary company’s financial statements are combined or consolidated with those of a parent company. The parent company buys an interest in a subsidiary, and the subsidiary’s assets and liabilities are presented at fair market value for each account.
Practice trading with virtual money
Find out what a hypothetical investment would be worth today.
TSLA
TESLA INC
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APPLE INC
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NIKE INC
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AMAZON.COM, INC
WMT
WALMART INC
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Fair Value vs. Market Value
Fair value is a broad measure of an asset’s intrinsic worth and requires determining the right price between two parties depending on their interests, risk factors, and future goals for the asset. Fair value is most often used to gauge the true worth or intrinsic value of an asset.
Market value is the observed and actual value for which an asset or liability is exchanged. It reflects the current value of the investment as determined by actual market transactions, and can fluctuate more frequently than fair value.
What Is the Intrinsic Value of a Stock?
Fair value is the price an investor pays for a stock and may be considered the present value of the stock, when the stock’s intrinsic value is considered and the stock’s growth potential. The intrinsic value is calculated by dividing the value of the next year’s dividend by the rate of return minus the growth rate.
\begin{aligned}&P = \frac{ D1 }{ r } – g \\&\textbf{where:} \\&P = \text{Current stock price} \\&D1 = \text{Value of next year’s dividend} \\&g = \text{Constant growth rate expected} \\&r = \text{Required rate of return} \\\end{aligned}P=rD1−gwhere:P=Current stock priceD1=Value of next year’s dividendg=Constant growth rate expectedr=Required rate of return
How Is Fair Value Considered In the Accounting of Financial Assets?
Generally Accepted Accounting Principles and International Financial Reporting Standards use fair value in accounts comprised of derivatives and hedges, employee stock options, and financial assets and accept that financial markets are efficient and their prevailing prices are reliable measures of fair value.3
How Does the Securities and Exchange Commission Regulate Fair Value?
In 2020, the SEC implemented rule 2a-5 under the Investment Company Act of 1940 requiring funds to value their portfolio investments using the market value of their portfolio securities when market quotations are “readily available.” If data is not readily available or if the investment is not a security, the Act requires the fund to use the investment’s fair value.
The fair value is determined in good faith by the fund’s board who are required to establish fair value methodologies and oversee pricing services.4
What Is Historical Cost Accounting?
Fair value accounting measures assets and liabilities at estimates of their current value whereas historical cost accounting measures the value of an asset based on the original cost of an asset.
What Methods Are Used to Determine Fair Value?
A market approach uses the prices associated with actual market transactions for similar assets to derive a fair value. An income approach uses estimated future cash flows or earnings to determine the present value fair value. A cost approach uses the estimated cost to replace an asset to help find an item’s fair value.5
The Bottom Line
Fair value is the estimated price at which an asset is bought or sold when both the buyer and seller freely agree on a price. Individuals and businesses may compare current market value, growth potential, and replacement cost to determine the fair value of an asset. Fair value calculations help investors make financial choices and fair value accounting practices determine the value of assets and liabilities based on current market value.
We compute the Fair Value (Academic) of a company by using a discounted cash flow analysis with the academic formula for Intrinsic Value that forecasts cashflows into perpituity. We then rank firms in each Sector by their Intrinsic Value to find a value that is well suited to current market multiples. Over the long term our Fair Values will imply a 30% drop in price for the worst stocks and a 45% gain for the best stocks.
Our quality score compares profitability and balance sheet metrics to find high quality companies. Our computation includes ROIC, Net Margin, Gross Margin, Interest Coverage, and Debt / Equity ratio values. The best companies score a 100 and the worst score a 0.
Our growth score looks at the 5 year history and also the forward estimates for EBITDA, Sales, and EPS growth to rank the best companies across all stocks with adequate data. The best companies score a 100 and the worst score a 0.
Our sentiment score finds stocks that the market favors by comparing Short Interest Ratios, the returns over several periods within the last year, Price vs. 52-wk High, Days Since 52-wk High and MACD signals. The best companies score a 100 and the worst score a 0.
Our value score looks at EV / EBITDA, P/E, EPS Predictability, Price / Tangible Book, and Price / Sales. The Price / Tangible Book and Price / Sales values are compared within a sector whereas the other metrics are compared across all stocks with adequate data. The best companies score a 100 and the worst score a 0.
The portion of shares that a company keeps in their own treasury. Treasury stock may have come from a repurchase or buyback from shareholders or it may have never been issued to the public in the first place. These shares don’t pay dividends, have no voting rights, and are not included in shares outstanding calculations.
difference between the estimated Forward analyst estimated forward EBIT for the next fiscal year and the last EBIT
EBIT is the acronym for earnings before interest and taxes. This income statement line relates to the profitability of a company’s business. EBIT may also be referred to as profit before interest and taxes. It is often conflated with Operating Income but has some key differences that we’ll review.
What EBIT Is
Business owners and investors frequently pay attention to EBIT, which is a company’s earnings before interest and taxes. EBIT appears on a company’s income statement, and its measurement assists business owners and investors in assessing profitability. EBIT answers the question of how much of a company’s revenues remain after operating expenses are deducted.
If a company’s EBIT is negative, the managers will either have to curb expenses or increase revenues to have a chance at becoming profitable.
EBIT Formula and Calculation
The EBIT formula subtracts the cost of goods sold (COGS) and operating expenses from the gross revenue. The formula looks like this:
EBIT = Gross Revenue – COGS – Operating Expenses
Cost of Goods Sold is found on the income statement just below revenues. There may be multiple lines that make up the COGS section and could include materials and labor costs. The operating expenses will be the next section and include overhead such as rent, equipment leasing, marketing, insurance, and research and development.
For example, ACME Widget Store spends $1 to create a widget. They make 1 million widgets in a quarter, but sell 800,000 of those widgets for a price of $2 per widget. Gross revenues are thus $1,600,000, while COGS for the quarter is reported as $800,000. On top of the COGS, they spend $12,000 per quarter in rent, $20,000 per quarter in sales and marketing, $3,000 per quarter on insurance, and $5,000 in equipment leasing. Adding these costs together means that the company has $40,000 in operating expenses for the quarter.
To determine the quarterly EBIT of ACME Widget Store, subtract the COGS and operating expenses from the gross revenue (EBIT = $1,600,000 – $800,000 – $40,000 = $760,000).
How EBIT Is Used
EBIT is a measure of a business’ operational profitability. It excludes taxes and interest so that the measure focuses solely on earnings from business operations. EBIT levels are dependent on volume of sales, product pricing, and cost efficiency.
EBIT isn’t only used internally to determine profitability. It is often used in conjunction with Enterprise Value (EV) by investors and analysts to assess a company’s relative value. Some investors are interested in how much EBIT a company generates in relation to its Enterprise Value. The EV is the market capitalization of the company plus net debt (debt – cash). If EV/EBIT ratio is low, a company may be considered undervalued (on this metric), and vice versa.
Important: Using EV/EBIT ratios, investors can compare the valuations of companies without regard to tax bracket or corporate structures.
For example, let’s look at two hypothetical company valuations:
Company A:
EBIT of $2.5 million
Market capitalization of $20 million
$5 million in debt
$1 million in cash
Company B:
EBIT of $1.1 million
Market capitalization of $10 million
$6 million in debt
$0.5 million in cash
This means that Company A has an EV of $24 million while Company B has an EV of $15.5 million. Running the ratios:
Company A: $24 million / $2.5 million = 9.6x
Company B: $15.5 million / $1.1 million = 14.1x
On an EV/EBIT basis alone, Company A looks like it offers better value than Company B.
EBIT Limitations
Investors should be careful about using EBIT or EV/EBIT ratios in isolation to determine a company’s financial health and valuation appeal. While it gives good insight into the profitability of a firm’s business operations, it doesn’t take into consideration the company’s capital structure. For instance, even if a company reports strong EBIT numbers, if a company is highly leveraged, it may not be profitable at all once interest is deducted.
Warning: EBIT and EV/EBIT values shouldn’t be used in isolation in assessing a company.
EBIT Alternatives
An investor or business owner can look at some alternative measures to EBIT which may end up providing a different picture of the financial health of the company. Here are some EBIT alternatives and how they compare.
ratio of a company’s current share price compared to its per-share earnings (trailing twelve months). Low P/E value indicates a stock is relatively cheap compared to its earnings.
What Is the Price-to-Earnings (P/E) Ratio?
The price-to-earnings ratio is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.
P/E ratios are used by investors and analysts to determine the relative value of a company’s shares in an apples-to-apples comparison. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time.
P/E may be estimated on a trailing (backward-looking) or forward (projected) basis.
KEY TAKEAWAYS
The price-to-earnings (P/E) ratio relates a company’s share price to its earnings per share.
A high P/E ratio could mean that a company’s stock is overvalued, or that investors are expecting high growth rates in the future.
Companies that have no earnings or that are losing money do not have a P/E ratio because there is nothing to put in the denominator.
Two kinds of P/E ratios—forward and trailing P/E—are used in practice.
A P/E ratio holds the most value to an analyst when compared against similar companies in the same industry or for a single company across a period of time.
The Price To Earnings Ratio Explained
P/E Ratio Formula and Calculation
The formula and calculation used for this process are as follows.
\text{P/E Ratio} = \frac{\text{Market value per share}}{\text{Earnings per share}}P/E Ratio=Earnings per shareMarket value per share
To determine the P/E value, one must simply divide the current stock price by the earnings per share (EPS).
The current stock price (P) can be found simply by plugging a stock’s ticker symbol into any finance website, and although this concrete value reflects what investors must currently pay for a stock, the EPS is a slightly more nebulous figure.
EPS comes in two main varieties. TTM is a Wall Street acronym for “trailing 12 months”. This number signals the company’s performance over the past 12 months. The second type of EPS is found in a company’s earnings release, which often provides EPS guidance. This is the company’s best-educated guess of what it expects to earn in the future. These different versions of EPS form the basis of trailing and forward P/E, respectively.
Understanding the P/E Ratio
The price-to-earnings ratio (P/E) is one of the most widely used tools by which investors and analysts determine a stock’s relative valuation. The P/E ratio helps one determine whether a stock is overvalued or undervalued. A company’s P/E can also be benchmarked against other stocks in the same industry or against the broader market, such as the S&P 500 Index.
Sometimes, analysts are interested in long-term valuation trends and consider the P/E 10 or P/E 30 measures, which average the past 10 or past 30 years of earnings, respectively. These measures are often used when trying to gauge the overall value of a stock index, such as the S&P 500, because these longer-term measures can compensate for changes in the business cycle.
The P/E ratio of the S&P 500 has fluctuated from a low of around 5x (in 1917) to over 120x (in 2009 right before the financial crisis). The long-term average P/E for the S&P 500 is around 16x, meaning that the stocks that make up the index collectively command a premium 16 times greater than their weighted average earnings.1
Analysts and investors review a company’s P/E ratio when they determine if the share price accurately represents the projected earnings per share.
Forward Price-to-Earnings
These two types of EPS metrics factor into the most common types of P/E ratios: the forward P/E and the trailing P/E. A third and less common variation uses the sum of the last two actual quarters and the estimates of the next two quarters.
The forward (or leading) P/E uses future earnings guidance rather than trailing figures. Sometimes called “estimated price to earnings,” this forward-looking indicator is useful for comparing current earnings to future earnings and helps provide a clearer picture of what earnings will look like—without changes and other accounting adjustments.
However, there are inherent problems with the forward P/E metric—namely, companies could underestimate earnings in order to beat the estimated P/E when the next quarter’s earnings are announced. Other companies may overstate the estimate and later adjust it going into their next earnings announcement. Furthermore, external analysts may also provide estimates, which may diverge from the company estimates, creating confusion.
Trailing Price-to-Earnings
The trailing P/E relies on past performance by dividing the current share price by the total EPS earnings over the past 12 months. It’s the most popular P/E metric because it’s the most objective—assuming the company reported earnings accurately. Some investors prefer to look at the trailing P/E because they don’t trust another individual’s earnings estimates. But the trailing P/E also has its share of shortcomings—namely, that a company’s past performance doesn’t signal future behavior.
Investors should thus commit money based on future earnings power, not the past. The fact that the EPS number remains constant, while the stock prices fluctuate, is also a problem. If a major company event drives the stock price significantly higher or lower, the trailing P/E will be less reflective of those changes.
The trailing P/E ratio will change as the price of a company’s stock moves because earnings are only released each quarter, while stocks trade day in and day out. As a result, some investors prefer the forward P/E. If the forward P/E ratio is lower than the trailing P/E ratio, it means analysts are expecting earnings to increase; if the forward P/E is higher than the current P/E ratio, analysts expect them to decrease.
Valuation From P/E
The price-to-earnings ratio or P/E is one of the most widely used stock analysis tools by which investors and analysts determine stock valuation. In addition to showing whether a company’s stock price is overvalued or undervalued, the P/E can reveal how a stock’s valuation compares to its industry group or a benchmark like the S&P 500 Index.
In essence, the price-to-earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive $1 of that company’s earnings. This is why the P/E is sometimes referred to as the price multiple because it shows how much investors are willing to pay per dollar of earnings. If a company was currently trading at a P/E multiple of 20x, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.
The P/E ratio helps investors determine the market value of a stock as compared to the company’s earnings. In short, the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E could mean that a stock’s price is high relative to earnings and possibly overvalued. Conversely, a low P/E might indicate that the current stock price is low relative to earnings.
Example of the P/E Ratio
As a historical example, let’s calculate the P/E ratio for Walmart Inc. (WMT) as of Feb. 3, 2021, when the company’s stock price closed at $139.55.2 The company’s earnings per share for the fiscal year ending Jan. 31, 2021, was $4.75, according to The Wall Street Journal.3
Therefore, Walmart’s P/E ratio was:
$139.55 / $4.75 = 29.38
Comparing Companies Using P/E
As an additional example, we can look at two financial companies to compare their P/E ratios and see which is relatively over- or undervalued.
Bank of America Corporation (BAC) closed out the year 2020 with the following stats:
Stock Price = $30.31
Diluted EPS = $1.87
P/E = 16.21x ($30.31 / $1.87)4
In other words, Bank of America traded at roughly 16x trailing earnings. However, the 16.21 P/E multiple by itself isn’t helpful unless you have something to compare it with, such as the stock’s industry group, a benchmark index, or Bank of America’s historical P/E range.
Bank of America’s P/E at 16x was slightly higher than the S&P 500, which over time trades at about 15x trailing earnings. To compare Bank of America’s P/E to a peer’s, we can calculate the P/E for JPMorgan Chase & Co. (JPM) as of the end of 2020 as well:
Stock Price = $127.07
Diluted EPS = $8.88
P/E = 14.31x5
When you compare Bank of America’s P/E of 16x to JPMorgan’s P/E of roughly 14x, Bank of America’s stock does not appear as overvalued as it did when compared with the average P/E of 15 for the S&P 500. Bank of America’s higher P/E ratio might mean investors expected higher earnings growth in the future compared to JPMorgan and the overall market.
However, no single ratio can tell you all you need to know about a stock. Before investing, it is wise to use a variety of financial ratios to determine whether a stock is fairly valued and whether a company’s financial health justifies its stock valuation.
Investor Expectations
In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. A low P/E can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends. When a company has no earnings or is posting losses, in both cases, the P/E will be expressed as N/A. Though it is possible to calculate a negative P/E, this is not the common convention.
The price-to-earnings ratio can also be seen as a means of standardizing the value of $1 of earnings throughout the stock market. In theory, by taking the median of P/E ratios over a period of several years, one could formulate something of a standardized P/E ratio, which could then be seen as a benchmark and used to indicate whether or not a stock is worth buying.
N/A Meaning
A P/E ratio of N/A means the ratio is not available or not applicable for that company’s stock. A company can have a P/E ratio of N/A if it’s newly listed on the stock exchange and has not yet reported earnings, such as in the case of an initial public offering (IPO), but it also means a company has zero or negative earnings, Investors can thus interpret seeing N/A as a company reporting a net loss.
P/E vs. Earnings Yield
The inverse of the P/E ratio is the earnings yield (which can be thought of as the E/P ratio). The earnings yield is thus defined as EPS divided by the stock price, expressed as a percentage.
If Stock A is trading at $10, and its EPS for the past year was 50 cents (TTM), it has a P/E of 20 (i.e., $10 / 50 cents) and an earnings yield of 5% (50 cents / $10). If Stock B is trading at $20 and its EPS (TTM) was $2, it has a P/E of 10 (i.e., $20 / $2) and an earnings yield of 10% = ($2 / $20).
The earnings yield as an investment valuation metric is not as widely used as the P/E ratio. Earnings yields can be useful when concerned about the rate of return on investment. For equity investors, however, earning periodic investment income may be secondary to growing their investments’ values over time. This is why investors may refer to value-based investment metrics such as the P/E ratio more often than earnings yield when making stock investments.
The earnings yield is also useful in producing a metric when a company has zero or negative earnings. Because such a case is common among high-tech, high-growth, or startup companies, EPS will be negative producing an undefined P/E ratio (denoted as N/A). If a company has negative earnings, however, it will produce a negative earnings yield, which can be interpreted and used for comparison.
P/E vs. PEG Ratio
A P/E ratio, even one calculated using a forward earnings estimate, doesn’t always tell you whether the P/E is appropriate for the company’s forecasted growth rate. So, to address this limitation, investors turn to another ratio called the PEG ratio.
A variation on the forward P/E ratio is the price/earnings-to-growth ratio, or PEG. The PEG ratio measures the relationship between the price/earnings ratio and earnings growth to provide investors with a more complete story than the P/E can on its own. In other words, the PEG ratio allows investors to calculate whether a stock’s price is overvalued or undervalued by analyzing both today’s earnings and the expected growth rate for the company in the future. The PEG ratio is calculated as a company’s trailing price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period.
The PEG ratio is used to determine a stock’s value based on trailing earnings while also taking the company’s future earnings growth into account and is considered to provide a more complete picture than the P/E ratio can. For example, a low P/E ratio may suggest that a stock is undervalued and therefore should be bought—but factoring in the company’s growth rate to get its PEG ratio can tell a different story. PEG ratios can be termed “trailing” if using historic growth rates or “forward” if using projected growth rates.
Although earnings growth rates can vary among different sectors, a stock with a PEG of less than 1 is typically considered undervalued because its price is considered low compared to the company’s expected earnings growth. A PEG greater than 1 might be considered overvalued because it might indicate the stock price is too high compared to the company’s expected earnings growth.
Absolute vs. Relative P/E
Analysts may also make a distinction between absolute P/E and relative P/E ratios in their analysis.
Absolute P/E
The numerator of this ratio is usually the current stock price, and the denominator may be the trailing EPS (TTM), the estimated EPS for the next 12 months (forward P/E), or a mix of the trailing EPS of the last two quarters and the forward P/E for the next two quarters.
When distinguishing absolute P/E from relative P/E, it is important to remember that absolute P/E represents the P/E of the current time period. For example, if the price of the stock today is $100, and the TTM earnings are $2 per share, the P/E is 50 = ($100 / $2).
Relative P/E
The relative P/E compares the current absolute P/E to a benchmark or a range of past P/Es over a relevant time period, such as the past 10 years. The relative P/E shows what portion or percentage of the past P/Es the current P/E has reached. The relative P/E usually compares the current P/E value to the highest value of the range, but investors might also compare the current P/E to the bottom side of the range, measuring how close the current P/E is to the historic low.
The relative P/E will have a value below 100% if the current P/E is lower than the past value (whether the past high or low). If the relative P/E measure is 100% or more, this tells investors that the current P/E has reached or surpassed the past value.
Limitations of Using the P/E Ratio
Like any other fundamental designed to inform investors as to whether or not a stock is worth buying, the price-to-earnings ratio comes with a few limitations that are important to take into account because investors may often be led to believe that there is one single metric that will provide complete insight into an investment decision, which is virtually never the case.
Companies that aren’t profitable and, consequently, have no earnings—or negative earnings per share—pose a challenge when it comes to calculating their P/E. Opinions vary as to how to deal with this. Some say there is a negative P/E, others assign a P/E of 0, while most just say the P/E doesn’t exist (N/A or not available) or is not interpretable until a company becomes profitable for purposes of comparison.
One primary limitation of using P/E ratios emerges when comparing the P/E ratios of different companies. Valuations and growth rates of companies may often vary wildly between sectors due to both the different ways companies earn money and the differing timelines during which companies earn that money.
As such, one should only use P/E as a comparative tool when considering companies in the same sector because this kind of comparison is the only kind that will yield productive insight. Comparing the P/E ratios of a telecommunications company and an energy company, for example, may lead one to believe that one is clearly the superior investment, but this is not a reliable assumption.
Other P/E Considerations
An individual company’s P/E ratio is much more meaningful when taken alongside the P/E ratios of other companies within the same sector. For example, an energy company may have a high P/E ratio, but this may reflect a trend within the sector rather than one merely within the individual company. An individual company’s high P/E ratio, for example, would be less cause for concern when the entire sector has high P/E ratios.
Moreover, because a company’s debt can affect both the prices of shares and the company’s earnings, leverage can skew P/E ratios as well. For example, suppose there are two similar companies that differ primarily in the amount of debt they assume. The one with more debt will likely have a lower P/E value than the one with less debt. However, if business is good, the one with more debt stands to see higher earnings because of the risks it has taken.
Another important limitation of price-to-earnings ratios is one that lies within the formula for calculating P/E itself. Accurate and unbiased presentations of P/E ratios rely on accurate inputs of the market value of shares and of accurate earnings per share estimates. The market determines the prices of shares through its continuous auction. The printed prices are available from a wide variety of reliable sources. However, the source for earnings information is ultimately the company itself. This single source of data is more easily manipulated, so analysts and investors place trust in the company’s officers to provide accurate information. If that trust is perceived to be broken, the stock will be considered riskier and therefore less valuable.
To reduce the risk of inaccurate information, the P/E ratio is but one measurement that analysts scrutinize. If the company were to intentionally manipulate the numbers to look better, and thus deceive investors, they would have to work strenuously to be certain that all metrics were manipulated in a coherent manner, which is difficult to do. That’s why the P/E ratio continues to be one of the most centrally referenced points of data when analyzing a company, but by no means is it the only one.
What Is a Good Price-to-Earnings Ratio?
The question of what is a good or bad price-to-earnings ratio will necessarily depend on the industry in which the company is operating. Some industries will have higher average price-to-earnings ratios, while others will have lower ratios. For example, in January 2021, publicly traded broadcasting companies had an average trailing P/E ratio of only about 12, compared to more than 60 for software companies.6 If you want to get a general idea of whether a particular P/E ratio is high or low, you can compare it to the average P/E of the competitors within its industry.
Is It Better to Have a Higher or Lower P/E Ratio?
Many investors will say that it is better to buy shares in companies with a lower P/E because this means you are paying less for every dollar of earnings that you receive. In that sense, a lower P/E is like a lower price tag, making it attractive to investors looking for a bargain. In practice, however, it is important to understand the reasons behind a company’s P/E. For instance, if a company has a low P/E because its business model is fundamentally in decline, then the apparent bargain might be an illusion.
What Does a P/E Ratio of 15 Mean?
Simply put, a P/E ratio of 15 would mean that the current market value of the company is equal to 15 times its annual earnings. Put literally, if you were to hypothetically buy 100% of the company’s shares, it would take 15 years for you to earn back your initial investment through the company’s ongoing profits assuming the company never grew in the future.
Why Is the P/E Ratio Important?
The P/E ratio helps investors determine whether the stock of a company is overvalued or undervalued compared to its earnings. The ratio is a measurement of what the market is willing to pay for the current operations as well as the prospective growth of the company. If a company is trading at a high P/E ratio, the market thinks highly of its growth potential and is willing to potentially overspend today based on future earnings.
A measure of the price-to-earnings ratio using forecasted earnings for the P/E calculation for the next fiscal year. If the earnings are expected to grow in the future, the forward P/E will be lower than the current P/E.
What Is Forward Price-to-Earnings (Forward P/E)?
Forward price-to-earnings (forward P/E) is a version of the ratio of price-to-earnings (P/E) that uses forecasted earnings for the P/E calculation. While the earnings used in this formula are just an estimate and not as reliable as current or historical earnings data, there are still benefits to estimated P/E analysis.
KEY TAKEAWAYS:
Forward P/E is a version of the ratio of price-to-earnings that uses forecasted earnings for the P/E calculation.1
Because forward P/E uses estimated earnings per share (EPS), it may produce incorrect or biased results if actual earnings prove to be different.
Analysts often combine forward and trailing P/E estimates to make a better judgment.
The forecasted earnings used in the formula below are typically either projected earnings for the following 12 months or the next full-year fiscal (FY) period. The forward P/E can be contrasted with the trailing P/E ratio.
\text{Forward } P/E = \frac{\text{Current Share Price}}{\text{Estimated Future Earnings per Share}}Forward P/E=Estimated Future Earnings per ShareCurrent Share Price
For example, assume that a company has a current share price of $50 and this year’s earnings per share are $5. Analysts estimate that the company’s earnings will grow by 10% over the next fiscal year. The company has a current P/E ratio of $50 / 5 = 10x.
The forward P/E, on the other hand, would be $50 / (5 x 1.10) = 9.1x. Note that the forward P/E is smaller than the current P/E since the forward P/E accounts for future earnings growth relative to today’s share price.
What Does Forward Price-to-Earnings Reveal?
Analysts like to think of the P/E ratio as a price tag on earnings. It is used to calculate a relative value based on a company’s level of earnings. In theory, $1 of earnings at company A is worth the same as $1 of earnings at company B. If this is the case, both companies should also be trading at the same price, but this is rarely the case.
If company A is trading for $5, and company B is trading for $10, this implies that the market values company B’s earnings more. There can be various interpretations as to why company B is valued more. It could mean that company B’s earnings are overvalued. It could also mean that company B deserves a premium on the value of its earnings due to superior management and a better business model.
When calculating the trailing P/E ratio, analysts compare today’s price against earnings for the last 12 months or the last fiscal year. However, both are based on historical prices. Analysts use earnings estimates to determine what the relative value of the company will be at a future level of earnings. The forward P/E estimates the relative value of the earnings.
For example, if the current price of company B is $10, and earnings are estimated to double next year to $2, the forward P/E ratio is 5x, or half the value of the company when it made $1 in earnings. If the forward P/E ratio is lower than the current P/E ratio, this implies that analysts are expecting earnings to increase. If the forward P/E is higher than the current P/E ratio, analysts expect a decrease in earnings.
Forward P/E vs. Trailing P/E
Forward P/E uses projected EPS. Meanwhile, trailing P/E relies on past performance by dividing the current share price by the total EPS earnings over the past 12 months. Trailing P/E is the most popular P/E metric because it’s the most objective—assuming the company reported earnings accurately. Some investors prefer to look at the trailing P/E because they don’t trust another individual’s earnings estimates.
However, trailing P/E also has its share of shortcomings—namely, a company’s past performance does not signal future behavior. Investors should thus commit money based on future earnings power, not the past. The fact that the EPS number remains constant while the stock prices fluctuate is also a problem. If a major company event drives the stock price significantly higher or lower, the trailing P/E will be less reflective of those changes.
Limitations of Forward P/E
Since forward P/E relies on estimated future earnings, it is subject to miscalculation and/or analysts’ bias. There are other inherent problems with the forward P/E also. Companies could underestimate earnings to beat the consensus estimate P/E when the next quarter’s earnings are announced.
Other companies may overstate the estimate and later adjust it going into their next earnings announcement. Furthermore, external analysts may also provide estimates, which may diverge from the company estimates, creating confusion.
If you’re using forward P/E as the central basis of your investment thesis, research the companies thoroughly. If the company updates its guidance, this will affect the forward P/E in a way that might cause you to change your opinion. It is good practice to use both forward and trailing P/E to come to a more trustworthy figure.
How to Calculate Forward P/E in Excel
You can calculate a company’s forward P/E for the next fiscal year in Microsoft Excel. As shown above, the formula for the forward P/E is simply a company’s market price per share divided by its expected earnings per share. In Microsoft Excel, first increase the widths of columns A, B, and C by right-clicking on each of the columns and left-clicking on “Column Width” and change the value to 30.
Assume you wanted to compare the forward P/E ratio between two companies in the same sector. Enter the name of the first company into cell B1 and the name of the second company into cell C1. Then:
Enter “Market price per share” into cell A2, and the corresponding values for the companies’ market price per share into cells B2 and C2.
Next, enter “Forward earnings per share” into cell A3, and the corresponding value for the companies’ expected EPS for the next fiscal year into cells B3 and C3.
Then, enter “Forward price to earnings ratio” into cell A4.
For example, assume company ABC is currently trading at $50 and has an expected EPS of $2.60. Enter “Company ABC” into cell B1. Next, enter “=50” into cell B2 and “=2.6” into cell B3. Then, enter “=B2/B3” into cell B4. The resulting forward P/E ratio for company ABC is 19.23.
On the other hand, company DEF currently has a market value per share of $30 and has an expected EPS of $1.80. Enter “Company DEF” into cell C1. Next, enter “=30” into cell C2 and “=1.80” into cell C3. Then, enter “=C2/C3” into cell C4. The resulting forward P/E for company DEF is 16.67.
A ratio used to determine a stock’s value while taking into account the earnings’ growth. PEG is used to measure a stock’s valuation (P/E) against its projected 3-5 year growth rate. It is favored by many over the price/earnings ratio because it also takes growth into account. A lower PEG ratio indicates that a stock is undervalued.
What Is the Price/Earnings-to-Growth (PEG) Ratio?
The price/earnings to growth ratio (PEG ratio) is a stock’s price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period.
The PEG ratio is used to determine a stock’s value while also factoring in the company’s expected earnings growth, and it is thought to provide a more complete picture than the more standard P/E ratio.
KEY TAKEAWAYS
The PEG ratio enhances the P/E ratio by adding expected earnings growth into the calculation.
The PEG ratio is considered to be an indicator of a stock’s true value, and similar to the P/E ratio, a lower PEG may indicate that a stock is undervalued.
The PEG for a given company may differ significantly from one reported source to another.
Differences will depend on which growth estimate is used in the calculation, such as one-year or three-year projected growth.
A PEG lower than 1.0 is best, suggesting that a company is relatively undervalued.
PEG Ratio
How to Calculate the PEG Ratio
\begin{aligned} &\text{PEG Ratio}=\frac{\text{Price/EPS}}{\text{EPS Growth}}\\ &\textbf{where:}\\ &\text{EPS = The earnings per share}\\ \end{aligned}PEG Ratio=EPS GrowthPrice/EPSwhere:EPS = The earnings per share
To calculate the PEG ratio, an investor or analyst needs to either look up or calculate the P/E ratio of the company in question. The P/E ratio is calculated as the price per share of the company divided by the earnings per share (EPS), or price per share / EPS.
Once the P/E is calculated, find the expected growth rate for the stock in question, using analyst estimates available on financial websites that follow the stock. Plug the figures into the equation, and solve for the PEG ratio number.
Accuracy
As with any ratio, the accuracy of the PEG ratio depends on the inputs used. When considering a company’s PEG ratio from a published source, it’s important to find out which growth rate was used in the calculation. In an article from Morgan Stanley Wealth Management, for example, the PEG ratio is calculated using a P/E ratio based on current-year data and a five-year expected growth rate.1
Using historical growth rates, for example, may provide an inaccurate PEG ratio if future growth rates are expected to deviate from a company’s historical growth. The ratio can be calculated using one-year, three-year, or five-year expected growth rates, for example.
To distinguish between calculation methods using future growth and historical growth, the terms “forward PEG” and “trailing PEG” are sometimes used.
What Does the PEG Ratio Tell You?
While a low P/E ratio may make a stock look like a good buy, factoring in the company’s growth rate to get the stock’s PEG ratio may tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its future earnings expectations. Adding a company’s expected growth into the ratio helps to adjust the result for companies that may have a high growth rate and a high P/E ratio.
The degree to which a PEG ratio result indicates an over or underpriced stock varies by industry and by company type. As a broad rule of thumb, some investors feel that a PEG ratio below one is desirable.
According to well-known investor Peter Lynch, a company’s P/E and expected growth should be equal, which denotes a fairly valued company and supports a PEG ratio of 1.0. When a company’s PEG exceeds 1.0, it’s considered overvalued while a stock with a PEG of less than 1.0 is considered undervalued.2
Example of How to Use the PEG Ratio
The PEG ratio provides useful information to compare companies and see which stock might be the better choice for an investor’s needs, as follows.
Assume the following data for two hypothetical companies, Company A and Company B:
Company A:
Price per share = $46
EPS this year = $2.09
EPS last year = $1.74
Company B
Price per share = $80
EPS this year = $2.67
EPS last year = $1.78
Given this information, the following data can be calculated for each company:
Company A
P/E ratio = $46 / $2.09 = 22
Earnings growth rate = ($2.09 / $1.74) – 1 = 20%
PEG ratio = 22 / 20 = 1.1
Company B
P/E ratio = $80 / $2.67 = 30
Earnings growth rate = ($2.67 / $1.78) – 1 = 50%
PEG ratio = 30 / 50 = 0.6
Many investors may look at Company A and find it more attractive since it has a lower P/E ratio among the two companies. But compared to Company B, it doesn’t have a high enough growth rate to justify its current P/E. Company B is trading at a discount to its growth rate and investors purchasing it are paying less per unit of earnings growth. Based on its lower PEG, Company B may be relatively the better buy.
What Is Considered to Be a Good PEG Ratio?
In general, a good PEG ratio is one larger than 1.0. PEG ratios greater than 1.0 are generally considered unfavorable, suggesting a stock is overvalued. Meanwhile, PEG ratios lower than 1.0 are considered better, indicating a stock is relatively undervalued.
What Is Better: A Higher or Lower PEG Ratio?
Lower PEG ratios are better, especially ratios under 1.0.
What Does a Negative PEG Ratio Indicate?
A negative PEG can result from either negative earnings (losses), or a negative estimated growth rate. Either case suggests that a company may be in trouble.
The Bottom Line
While the P/E ratio is more commonly used by investors, the PEG ratio improves upon the P/E by incorporating earnings growth estimates. This provides a fuller picture of a company’s relative value in the market. However, because it relies on earnings estimates, having good estimates is key. A bad forecast or assumption, or naively projecting historical growth rates into the future, can produce unreliable PEG ratios.
A ratio that reflects the value placed on sales by the market. It is calculated by dividing the current closing price of the stock by the dollar-sales value per share. The ratio is often used to value unprofitable companies.
What Is the Price-to-Sales (P/S) Ratio?
The price-to-sales (P/S) ratio is a valuation ratio that compares a company’s stock price to its revenues. It is an indicator of the value that financial markets have placed on each dollar of a company’s sales or revenues.
KEY TAKEAWAYS
The price-to-sales (P/S) ratio shows how much investors are willing to pay per dollar of sales for a stock.
The P/S ratio is calculated by dividing the stock price by the underlying company’s sales per share.
A low ratio could imply the stock is undervalued, while a ratio that is higher-than-average could indicate that the stock is overvalued.
One of the downsides of the P/S ratio is that it doesn’t take into account whether the company makes any earnings or whether it will ever make earnings.
Understanding Price-to-Sales (P/S) Ratio
The P/S ratio is a key analysis and valuation tool for investors and analysts. The ratio shows how much investors are willing to pay per dollar of sales. It can be calculated either by dividing the company’s market capitalization by its total sales over a designated period (usually twelve months) or on a per-share basis by dividing the stock price by sales per share. The P/S ratio is also known as a sales multiple or revenue multiple.
Like all ratios, the P/S ratio is most relevant when used to compare companies in the same sector. A low ratio may indicate the stock is undervalued, while a ratio that is significantly above the average may suggest overvaluation.
The typical 12-month period used for sales in the P/S ratio is generally the past four quarters (also called trailing 12 months or TTM), or the most recent or current fiscal year (FY). A P/S ratio that is based on forecast sales for the current year is called a forward P/S ratio.
To determine the P/S ratio, one must divide the current stock price by the sales per share. The current stock price can be found by plugging the stock symbol into any major finance website. The sales per share metric is calculated by dividing a company’s sales by the number of outstanding shares.
\begin{aligned} &\text{P/S Ratio}=\frac{MVS}{SPS}\\ &\textbf{where:}\\ &MVS = \text{Market Value per Share}\\ &SPS = \text{Sales per Share}\\ \end{aligned}P/S Ratio=SPSMVSwhere:MVS=Market Value per ShareSPS=Sales per Share
As is the case with other ratios, the P/S ratio is of greatest value when it is used for comparing companies within the same sector.
The P/S ratio doesn’t take into account whether the company makes any earnings or whether it will ever make earnings. Comparing companies in different industries can prove difficult as well. For example, companies that make video games will have different capabilities when it comes to turning sales into profits when compared to, say, grocery retailers. In addition, P/S ratios do not account for debt loads or the status of a company’s balance sheet. That is, a company with virtually no debt will be more attractive than a highly leveraged company with the same P/S ratio.
While the P/S ratio doesn’t take debt into account, the enterprise value-to-sales ratio (EV/Sales) does. The EV/Sales ratio uses enterprise value and not market capitalization like the P/S ratio. Enterprise value adds debt and preferred shares to the market cap and subtracts cash. The EV/Sales ratio is said to be superior, although it involves more steps and isn’t always as readily available.
Examples of the Price-to-Sales (P/S) Ratio
As an example, consider the quarterly sales for Acme Co. shown in the table below. The sales for fiscal year 1 (FY1) are actual sales, while sales for FY2 are analysts’ average forecasts (assume that we are currently in the first quarter or Q1 of FY2). Acme has 100 million shares outstanding, with the shares presently trading at $10 per share.
FY1-Q1
FY1-Q2
FY1-Q3
FY1-Q4
FY2-Q1
FY2-Q2
FY2-Q3
FY2-Q4
Revenues ($ million)
$100
$110
$120
$125
$130
$135
$130
$125
At the present time, Acme’s P/S ratio on a trailing-12-month basis would be calculated as follows:
Sales for the past 12 months (TTM) = $455 million (sum of all FY1 values)
Sales per share (TTM) = $4.55 ($455 million in sales / 100 million shares outstanding)
P/S ratio = 2.2 ($10 share price / $4.55 sales per share)
Acme’s P/S ratio for the current fiscal year would be calculated as follows:
Sales for the current fiscal year (FY2) = $520 million
Sales per share = $5.20
P/S ratio = $10 / $5.20 = 1.92
If Acme’s peers—which we assume are based in the same sector and are of similar size in terms of market capitalization—are trading at an average P/S ratio (TTM) of 1.5, compared with Acme’s 2.2, it suggests a premium valuation for the company. One reason for this could be the 14.3% revenue growth that Acme is expected to post in the current fiscal year ($520 million versus $455 million), which may be better than what is expected for its peers.
Apple Example
Taking that a step further, consider Apple’s fiscal 2020 revenues of $274.5 billion.1 With 16.53 billion in outstanding shares as of Sept. 30, 2021, Apple’s sales per share are $16.60.2 With a stock price of $145, it would give the company a P/S ratio of 8.73.3
In comparison, Google trades with a P/S ratio of 6.29 and Microsoft at 10.87, suggesting that Apple and Google may potentially be undervalued or Microsoft might be overvalued.45
Why Is the Price-to-Sales (P/S) Ratio Useful to Investors?
The P/S ratio, also known as a sales multiple or revenue multiple, is a key analysis and valuation tool for investors and analysts. The ratio shows how much investors are willing to pay per dollar of sales. It can be calculated either by dividing the company’s market capitalization by its total sales over a designated period (usually twelve months) or on a per-share basis by dividing the stock price by sales per share. Like all ratios, the P/S ratio is most relevant when used to compare companies in the same sector. A low ratio may indicate the stock is undervalued, while a ratio that is significantly above the average may suggest overvaluation.
What Are the Limitations of the Price-to-Sales (P/S) Ratio?
The P/S ratio doesn’t take into account whether the company makes any earnings or whether it will ever make earnings. Comparing companies in different industries can prove difficult as well. For example, companies that make video games will have different capabilities when it comes to turning sales into profits when compared to, say, grocery retailers. In addition, P/S ratios do not account for debt loads or the status of a company’s balance sheet.
What Is Enterprise Value-to-Sales (EV/Sales)?
Enterprise value-to-sales (EV/sales) measures how much it would cost to purchase a company’s value in terms of its sales. A lower EV/sales multiple indicates that a company is a more attractive investment as it may be relatively undervalued. Essentially, it uses enterprise value and not market capitalization like the P/S ratio. Enterprise value adds debt and preferred shares to the market cap and subtracts cash. Since it does account for a company’s debt load, the EV/Sales ratio is said to be superior, although it involves more steps and isn’t always as readily available.
A ratio used to compare a stock’s market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share. A lower P/B ratio could mean that the stock is either undervalued or something is fundamentally wrong with the company.
What Is the Price-to-Book (P/B) Ratio?
Companies use the price-to-book ratio (P/B ratio) to compare a firm’s market capitalization to its book value. It’s calculated by dividing the company’s stock price per share by its book value per share (BVPS). An asset’s book value is equal to its carrying value on the balance sheet, and companies calculate it by netting the asset against its accumulated depreciation.
KEY TAKEAWAYS
The P/B ratio measures the market’s valuation of a company relative to its book value.
The market value of equity is typically higher than the book value of a company.
P/B ratio is used by value investors to identify potential investments.
P/B ratios under 1 are typically considered solid investments.
Understanding The P/B Ratio
Formula and Calculation of the Price-to-Book (P/B) Ratio
In this equation, book value per share is calculated as follows: (total assets – total liabilities) / number of shares outstanding). Market value per share is obtained by simply looking at the share price quote in the market.
A lower P/B ratio could mean the stock is undervalued. However, it could also mean something is fundamentally wrong with the company. As with most ratios, this varies by industry. The P/B ratio also indicates whether you’re paying too much for what would remain if the company went bankrupt immediately.
What the P/B Ratio Can Tell You
The P/B ratio reflects the value that market participants attach to a company’s equity relative to the book value of its equity. A stock’s market value is a forward-looking metric that reflects a company’s future cash flows. The book value of equity is an accounting measure based on the historic cost principle and reflects past issuances of equity, augmented by any profits or losses, and reduced by dividends and share buybacks.
The price-to-book ratio compares a company’s market value to its book value. The market value of a company is its share price multiplied by the number of outstanding shares. The book value is the net assets of a company.
In other words, if a company liquidated all of its assets and paid off all its debt, the value remaining would be the company’s book value. The P/B ratio provides a valuable reality check for investors seeking growth at a reasonable price and is often looked at in conjunction with return on equity (ROE), a reliable growth indicator. Large discrepancies between the P/B ratio and ROE often send up a red flag on companies. Overvalued growth stocks frequently show a combination of low ROE and high P/B ratios. If a company’s ROE is growing, its P/B ratio should also be growing.
P/B Ratios and Public Companies
It is difficult to pinpoint a specific numeric value of a “good” price-to-book (P/B) ratio when determining if a stock is undervalued and therefore a good investment. Ratio analysis can vary by industry. A good P/B ratio for one industry might be a poor ratio for another.
It’s helpful to identify some general parameters or a range for P/B value, and then consider various other factors and valuation measures that more accurately interpret the P/B value and forecast a company’s potential for growth.
The P/B ratio has been favored by value investors for decades and is widely used by market analysts. Traditionally, any value under 1.0 is considered a good P/B for value investors, indicating a potentially undervalued stock. However, value investors may often consider stocks with a P/B value under 3.0 as their benchmark.
Equity Market Value vs. Book Value
Due to accounting conventions on the treatment of certain costs, the market value of equity is typically higher than the book value of a company, resulting in a P/B ratio above 1.0. Under certain circumstances of financial distress, bankruptcy, or expected plunges in earnings power, a company’s P/B ratio can dive below a value of 1.0.
Because accounting principles do not recognize intangible assets such as the brand value, unless the company derived them through acquisitions, companies expense all costs associated with creating intangible assets immediately.
For example, companies must expense research and most development costs, reducing a company’s book value. However, these R&D outlays can create unique production processes for a company or result in new patents that can bring royalty revenues going forward. While accounting principles favor a conservative approach in capitalizing costs, market participants may raise the stock price because of such R&D efforts, resulting in wide differences between the market and book values of equity.
Example of How to Use the P/B Ratio
Assume that a company has $100 million in assets on the balance sheet and $75 million in liabilities. The book value of that company would be calculated simply as $25 million ($100M – $75M). If there are 10 million shares outstanding, each share would represent $2.50 of book value. If the share price is $5, then the P/B ratio would be 2x (5 / 2.50). This illustrates that the market price is valued at twice its book value.
P/B Ratio vs. Price-to-Tangible-Book Ratio
Closely related to the P/B ratio is the price to tangible book value ratio (PTBV). The latter is a valuation ratio expressing the price of a security compared to its hard, or tangible, book value as reported in the company’s balance sheet. The tangible book value number is equal to the company’s total book value less than the value of any intangible assets.
Intangible assets can be items such as patents, intellectual property, and goodwill. This may be a more useful measure of valuation when the market is valuing something like a patent in different ways or if it is difficult to put a value on such an intangible asset in the first place.
Limitations of Using the P/B Ratio
Investors find the P/B ratio useful because the book value of equity provides a relatively stable and intuitive metric they can easily compare to the market price. The P/B ratio can also be used for firms with positive book values and negative earnings since negative earnings render price-to-earnings ratios useless, and there are fewer companies with negative book values than companies with negative earnings.
However, when accounting standards applied by firms vary, P/B ratios may not be comparable, especially for companies from different countries. Additionally, P/B ratios can be less useful for service and information technology companies with little tangible assets on their balance sheets. Finally, the book value can become negative because of a long series of negative earnings, making the P/B ratio useless for relative valuation.
Other potential problems in using the P/B ratio stem from the fact that any number of scenarios, such as recent acquisitions, recent write-offs, or share buybacks can distort the book value figure in the equation. In searching for undervalued stocks, investors should consider multiple valuation measures to complement the P/B ratio.
What Does the Price-to-Book Ratio Compare?
The price-to-book ratio is one of the most widely-used financial ratios. It compares a company’s market price to its book value, essentially showing the value given by the market for each dollar of the company’s net worth. High-growth companies will often show price-to-book ratios well above 1.0, whereas companies facing severe distress will occasionally show ratios below 1.0.
Why Is the Price-to Book Ratio Important?
The price-to-book ratio is important because it can help investors understand whether the market price of a company seems reasonable when compared to its balance sheet. For example, if a company shows a high price-to-book ratio, investors might check to see whether that valuation is justified given other measures, such as its historical return on assets or growth in earnings per share (EPS). The price-to-book ratio is also frequently used to screen potential investment opportunities.
What Is a Good Price-to-Book Ratio?
What counts as a “good” price-to-book ratio will depend on the industry in question and the overall state of valuations in the market. For example, between 2010 and 2020 there was a steady rise in the average price-to-book ratio of the technology companies listed on the Nasdaq stock exchange.12
An investor assessing the price-to-book ratio of one of these technology companies might thus choose to accept a higher average price-to-book ratio, as compared to an investor looking at a company in a more traditional industry in which lower price-to-book ratios are the norm.
A ratio used to compare a stock’s market value to its cash assets. It is calculated by dividing the current closing price of the stock by the latest quarter’s cash per share.
Price to Cash
The Price to Cash Ratio attempts to value a share against the Cash it owns. It is the share price divided by the firm’s Cash. This figure is computed from the latest available interim accounts.
Stockopedia explains P / Cash
As with all of our Balance Sheet Ratios, this will be based on the latest financial statements (interim or annual) but it’s always important to be aware of any post-balance sheet events that may have reduced the cash balance – an acquisition or a buyback, for example. The market may be pricing in something that has not been captured by the snapshot given in the latest financial statements.
A valuation metric that compares a company’s market price to its level of annual free cash flow.
What Is the Price to Free Cash Flow Ratio?
Price to free cash flow (P/FCF) is an equity valuation metric that compares a company’s per-share market price to its free cash flow (FCF). This metric is very similar to the valuation metric of price to cash flow but is considered a more exact measure because it uses free cash flow, which subtracts capital expenditures (CAPEX) from a company’s total operating cash flow, thereby reflecting the actual cash flow available to fund non-asset-related growth.
Companies can use this metric to base growth decisions and maintain acceptable free cash flow levels.
KEY TAKEAWAYS
Price to free cash flow is an equity valuation metric that indicates a company’s ability to continue operating. It is calculated by dividing its market capitalization by free cash flow values.
Relative to competitor businesses, a lower value for price to free cash flow indicates that the company is undervalued and its stock is relatively cheap.
Relative to competitor businesses, a higher value for price to free cash flow indicates a company’s stock is overvalued.
The price to free cash flow ratio can be used to compare a company’s stock value to its cash management practices over time.
Understanding the Price to Free Cash Flow Ratio
A company’s free cash flow is essential because it is a primary indicator of its ability to generate additional revenues, which is a crucial element in stock pricing.
The price to free cash flow metric is calculated as follows:
For example, a company with $100 million in total operating cash flow and $50 million in capital expenditures has a free cash flow total of $50 million. If the company’s market cap value is $1 billion, it has a ratio of 20, meaning its stock trades at 20 times its free cash flow – $1 billion / $50 million.
You might find a company that has more free cash flows than it does market cap or one that is very close to equal amounts of both. For example, a market cap of 102 million and free cash flows of 110 million would result in a ratio of .93. There is nothing inherently wrong with this if it is typical for the company’s industry. However, suppose the company operates in an industry where comparable company market caps hover around 200 million. In that case, you may want to investigate further to determine why the business’s market cap is low.
Free cash flows or market caps that are non-typical for a company’s size and industry should raise the flag for further investigation. The business might be in financial trouble, or it might not—it’s critical to find out.
How Is the Price to Free Cash Flow Ratio Used?
Because the price to free cash flow ratio is a value metric, lower numbers generally indicate that a company is undervalued and its stock is relatively cheap in relation to its free cash flow. Conversely, higher price to free cash flow numbers may indicate that the company’s stock is somewhat overvalued in relation to its free cash flow.
Therefore, value investors tend to favor companies with low or decreasing P/FCF values that indicate high or increasing free cash flow totals and relatively low stock share prices compared to similar companies in the same industry.
The price to free cash flow ratio is a comparative metric that needs to be compared to something to mean anything. Past P/FCF ratios, competitor ratios, or industry norms are comparable ratios that can be used to gauge value.
They tend to avoid companies with high price to free cash flow values that indicate the company’s share price is relatively high compared to its free cash flow. In short, the lower the price to free cash flow, the more a company’s stock is considered to be a better bargain or value.
As with any equity evaluation metric, it is most useful to compare a company’s P/FCF to that of similar companies in the same industry. However, the price to free cash flow metric can also be viewed over a long-term time frame to see if the company’s cash flow to share price value is generally improving or worsening.
The Ratio Can Be Manipulated
The price to free cash flow ratio can be manipulated by a company. For example, you might find some that preserve cash levels in a reporting period by delaying inventory purchases or their accounts payable payments until after they have published their financial statements.
The fact that reported numbers can be manipulated makes it essential that you analyze a company’s finances entirely to achieve a larger picture of how it is doing financially. When you do this over a few reporting periods, you can see what a company is doing with its cash, how it is using it, and how other investors value the company.
What Is a Good Price to Free Cash Flow Ratio?
A good price to free cash flow ratio is one that indicates its stock is undervalued. A company’s P/FCF should be compared to the ratios of similar companies to determine whether it is under- or over-valued in the industry it operates in. Generally speaking, the lower the ratio, the cheaper the stock is.
Is a High Price to Free Cash Flow Ratio Good?
A high ratio—one that is higher than is typical for the industry it operates in—may indicate a company’s stock is overvalued.
Is Price to Cash Flow the Same as Price to Free Cash Flow?
Price to cash flow accounts for all cash a company has. Price to free cash flow removes capital expenditures, working capital, and dividends so that you compare the cash a company has left over after obligations to its stock price. As a result, it is a better indicator of the ability of a business to continue operating.
The dividend yield equals the annual dividend per share divided by the stock’s price. This measurement tells what percentage return a company pays out to shareholders in the form of dividends. Investors who require a minimum stream of cash flow from their investment portfolio can secure this cash flow by investing in stocks paying relatively high, stable dividend yields
What Is the Dividend Yield?
The dividend yield, expressed as a percentage, is a financial ratio (dividend/price) that shows how much a company pays out in dividends each year relative to its stock price.
The reciprocal of the dividend yield is the price/dividend or the dividend payout ratio.
KEY TAKEAWAYS
The dividend yield—displayed as a percentage—is the amount of money a company pays shareholders for owning a share of its stock divided by its current stock price.
Mature companies are the most likely to pay dividends.
Companies in the utility and consumer staple industries often have relatively higher dividend yields.
Real estate investment trusts (REITs), master limited partnerships (MLPs), and business development companies (BDCs) pay higher than average dividends; however, the dividends from these companies are taxed at a higher rate.
It’s important for investors to keep in mind that higher dividend yields do not always indicate attractive investment opportunities because the dividend yield of a stock may be elevated as a result of a declining stock price.
Understanding the Dividend Yield
The dividend yield is an estimate of the dividend-only return of a stock investment. Assuming the dividend is not raised or lowered, the yield will rise when the price of the stock falls. And conversely, it will fall when the price of the stock rises. Because dividend yields change relative to the stock price, it can often look unusually high for stocks that are falling in value quickly.
New companies that are relatively small, but still growing quickly, may pay a lower average dividend than mature companies in the same sectors. In general, mature companies that aren’t growing very quickly pay the highest dividend yields. Consumer non-cyclical stocks that market staple items or utilities are examples of entire sectors that pay the highest average yield.
Although the dividend yield among technology stocks is lower than average, the same general rule that applies to mature companies also applies to the technology sector. For example, as of June 2021, Qualcomm Incorporated (QCOM), an established telecommunications equipment manufacturer, had a trailing twelve months (TTM) dividend of $2.63.1 Using its current price of $144.41 on August 17, 2021, its dividend yield would be 1.82%.2 Meanwhile, Square, Inc. (SQ), a relatively newer mobile payments processor, pays no dividends at all.3
REITs, MLPs, and BDCs
In some cases, the dividend yield may not provide that much information about what kind of dividend the company pays. For example, the average dividend yield in the market is very high amongst real estate investment trusts (REITs). However, those are the yields from ordinary dividends, which are different than qualified dividends in that the former is taxed as regular income while the latter is taxed as capital gains.4
Along with REITs, master limited partnerships (MLPs) and business development companies (BDCs) typically have very high dividend yields. The structure of these companies is such that the U.S. Treasury requires them to pass on the majority of their income to their shareholders.5 This is referred to as a “pass-through” process, and it means that the company doesn’t have to pay income taxes on profits that it distributes as dividends. However, the shareholder has to treat the dividend payments as ordinary income and pay taxes on them. Dividends from these types of companies (MLPs and BDCs) do not qualify for capital gains tax treatment.67
While the higher tax liability on dividends from ordinary companies lowers the effective yield the investor has earned, even when adjusted for taxes, REITs, MLPs, and BDCs still pay dividends with a higher-than-average yield.
Calculating the Dividend Yield
The formula for dividend yield is as follows:
\begin{aligned}&\text{Dividend Yield} = \frac{ \text{Annual Dividends Per Share} }{ \text{Price Per Share} } \\\end{aligned}Dividend Yield=Price Per ShareAnnual Dividends Per Share
The dividend yield can be calculated from the last full year’s financial report. This is acceptable during the first few months after the company has released its annual report; however, the longer it has been since the annual report, the less relevant that data is for investors. Alternatively, investors can also add the last four quarters of dividends, which captures the trailing 12 months of dividend data. Using a trailing dividend number is acceptable, but it can make the yield too high or too low if the dividend has recently been cut or raised.
Because dividends are paid quarterly, many investors will take the last quarterly dividend, multiply it by four, and use the product as the annual dividend for the yield calculation. This approach will reflect any recent changes in the dividend, but not all companies pay an even quarterly dividend. Some firms, especially outside the U.S., pay a small quarterly dividend with a large annual dividend. If the dividend calculation is performed after the large dividend distribution, it will give an inflated yield.
Finally, some companies pay a dividend more frequently than quarterly. A monthly dividend could result in a dividend yield calculation that is too low. When deciding how to calculate the dividend yield, an investor should look at the history of dividend payments to decide which method will give the most accurate results.
Advantages of Dividend Yields
Historical evidence suggests that a focus on dividends may amplify returns rather than slow them down. For example, according to analysts at Hartford Funds, since 1970, 84% of the total returns from the S&P 500 are from dividends. This assumption is based on the fact that investors are likely to reinvest their dividends back into the S&P 500, which then compounds their ability to earn more dividends in the future.8
For example, suppose an investor buys $10,000 worth of a stock with a dividend yield of 4% at a rate of a $100 share price. This investor owns 100 shares that all pay a dividend of $4 per share (100 x $4 = $400 total). Assume that the investor uses the $400 in dividends to purchase four more shares. The price would be adjusted on the ex-dividend date by $4 per share to $96 per share. Reinvesting would purchase 4.16 shares; dividend reinvestment programs allow for fractional share purchases. If nothing else changes, the next year the investor will have 104.16 shares worth $10,416. This amount can be reinvested into more shares once a dividend is declared, thus compounding gains similar to a savings account.
Disadvantages of Dividend Yields
While high dividend yields are attractive, it’s possible they may be at the expense of the potential growth of the company. It can be assumed that every dollar a company is paying in dividends to its shareholders is a dollar that the company is not reinvesting to grow and generate more capital gains. Even without earning any dividends, shareholders have the potential to earn higher returns if the value of their stock increases while they hold it as a result of company growth.
It’s not recommended that investors evaluate a stock based on its dividend yield alone. Dividend data can be old or based on erroneous information. Many companies have a very high yield as their stock is falling. If a company’s stock experiences enough of a decline, it may reduce the amount of the dividend, or eliminate it altogether.
Investors should exercise caution when evaluating a company that looks distressed and has a higher-than-average dividend yield. Because the stock’s price is the denominator of the dividend yield equation, a strong downtrend can increase the quotient of the calculation dramatically.
For example, General Electric Company’s (GE) manufacturing and energy divisions began underperforming from 2015 through 2018, and the stock’s price fell as earnings declined. The dividend yield jumped from 3% to more than 5% as the price dropped.9 As you can see in the following chart, the decline in the share price and eventual cut to the dividend offset any benefit of the high dividend yield.
Dividend Yield vs. Dividend Payout Ratio
When comparing measures of corporate dividends, it’s important to note that the dividend yield tells you what the simple rate of return is in the form of cash dividends to shareholders. However, the dividend payout ratio represents how much of a company’s net earnings are paid out as dividends. While the dividend yield is the more commonly used term, many believe the dividend payout ratio is a better indicator of a company’s ability to distribute dividends consistently in the future. The dividend payout ratio is highly connected to a company’s cash flow.
The dividend yield shows how much a company has paid out in dividends over the course of a year. The yield is presented as a percentage, not as an actual dollar amount. This makes it easier to see how much return the shareholder can expect to receive per dollar they have invested.
Example of Dividend Yield
Suppose Company A’s stock is trading at $20 and pays annual dividends of $1 per share to its shareholders. Suppose that Company B’s stock is trading at $40 and also pays an annual dividend of $1 per share.
This means Company A’s dividend yield is 5% ($1 / $20), while Company B’s dividend yield is only 2.5% ($1 / $40). Assuming all other factors are equivalent, an investor looking to use their portfolio to supplement their income would likely prefer Company A over Company B because it has double the dividend yield.
What Does the Dividend Yield Tell You?
The dividend yield is a financial ratio that tells you the percentage of a company’s share price that it pays out in dividends each year. For example, if a company has a $20 share price and pays a dividend of $1 per year, its dividend yield would be 5%. If a company’s dividend yield has been steadily increasing, this could be because they are increasing their dividend, because their share price is declining, or both. Depending on the circumstances, this may be seen as either a positive or a negative sign by investors.
Why Is Dividend Yield Important?
Some investors, such as retirees, are heavily reliant on dividends for their income. For these investors, the dividend yield of their portfolio could have a meaningful effect on their personal finances, making it very important for these investors to select dividend-paying companies with long track records and clear financial strength. For other investors, dividend yield may be less significant, such as for younger investors who are more interested in growth companies that can retain their earnings and use them to finance their growth.
Is a High Dividend Yield Good?
Yield-oriented investors will generally look for companies that offer high dividend yields, but it is important to dig deeper in order to understand the circumstances leading to the high yield. One approach taken by investors is to focus on companies that have a long track record of maintaining or raising their dividends, while also verifying that those companies have the underlying financial strength to continue paying dividends well into the future. To do so, investors can refer to other metrics such as the current ratio and the dividend payout ratio.
Which Stock Has the Highest Dividend Yield?
This will depend on the timeframe you look at. Dividend yields change daily as the prices of shares that pay dividends rise or fall. Some stocks with very high dividend yields may be the result of a recent downturn in share price, and oftentimes that dividend will be slashed or eliminated by the managers if the stock price does not soon recover.
The Bottom Line
Many stocks pay dividends to reward their shareholders and to signal sound financial footing to the investing public. The dividend yield is a measure of how high a company’s dividends are relative to its share price. High-yielding dividend stocks can be a good buy for some value investors, but may also signal that a stock’s share price has recently fallen by quite a bit, making the legacy dividend comparatively higher in relation to the share price. A high dividend yield could also suggest that a company is distributing too much profits as dividends rather than investing in growth opportunities or new projects.
The percentage of earnings paid to shareholders in dividends.
he payout ratio is a financial metric showing the proportion of earnings a company pays its shareholders in the form of dividends, expressed as a percentage of the company’s total earnings. On some occasions, the payout ratio refers to the dividends paid out as a percentage of a company’s cash flow. The payout ratio is also known as the dividend payout ratio.
KEY TAKEAWAYS
The payout ratio, also known as the dividend payout ratio, shows the percentage of a company’s earnings paid out as dividends to shareholders.
A low payout ratio can signal that a company is reinvesting the bulk of its earnings into expanding operations.
A payout ratio over 100% indicates that the company is paying out more in dividends than its earning can support, which some view as an unsustainable practice.
d to determine the sustainability of a company’s dividend payment program. It is the amount of dividends paid to shareholders relative to the total net income of a company.
For example, let’s assume Company ABC has earnings per share of $1 and pays dividends per share of $0.60. In this scenario, the payout ratio would be 60% (0.6 / 1). Let’s further assume that Company XYZ has earnings per share of $2 and dividends per share of $1.50. In this scenario, the payout ratio is 75% (1.5 / 2). Comparatively speaking, Company ABC pays out a smaller percentage of its earnings to shareholders as dividends, giving it a more sustainable payout ratio than Company XYZ.
While the payout ratio is an important metric for determining the sustainability of a company’s dividend payment program, other considerations should likewise be observed. Case in point: in the aforementioned analysis, if Company ABC is a commodity producer and Company XYZ is a regulated utility, the latter may boast greater dividend sustainability, even though the former demonstrates a lower absolute payout ratio.
In essence, there is no single number that defines an ideal payout ratio because the adequacy largely depends on the sector in which a given company operates. Companies in defensive industries, such as utilities, pipelines, and telecommunications, tend to boast stable earnings and cash flows that are able to support high payouts over the long haul.
On the other hand, companies in cyclical industries typically make less reliable payouts, because their profits are vulnerable to macroeconomic fluctuations. In times of economic hardship, people spend less of their incomes on new cars, entertainment, and luxury goods. Consequently, companies in these sectors tend to experience earnings peaks and valleys that fall in line with economic cycles.
Some companies pay out all their earnings to shareholders, while others dole out just a portion and funnel the remaining assets back into their businesses. The measure of retained earnings is known as the retention ratio. The higher the retention ratio is, the lower the payout ratio is. For example, if a company reports a net income of $100,000 and issues $25,000 in dividends, the payout ratio would be $25,000 / $100,000 = 25%. This implies that the company boasts a 75% retention ratio, meaning it records the remaining $75,000 of its income for the period in its financial statements as retained earnings, which appears in the equity section of the company’s balance sheet the following year.
Generally speaking, companies with the best long-term records of dividend payments have stable payout ratios over many years. But a payout ratio greater than 100% suggests a company is paying out more in dividends than its earnings can support and might be cause for concern regarding sustainability.
What Does the Payout Ratio Tell You?
The payout ratio is a key financial metric used to determine the sustainability of a company’s dividend payment program. It is the amount of dividends paid to shareholders relative to the total net income of a company. Generally, the higher the payout ratio, especially if it is over 100%, the more its sustainability is in question. Conversely, a low payout ratio can signal that a company is reinvesting the bulk of its earnings into expanding operations. Historically, companies with the best long-term records of dividend payments have had stable payout ratios over many years.
How Is the Payout Ratio Calculated?
The payout ratio shows the proportion of earnings a company pays its shareholders in the form of dividends, expressed as a percentage of the company’s total earnings. The calculation is derived by dividing the total dividends being paid out by the net income generated. Another way to express it is to calculate the dividends per share (DPS) and divide that by the earnings per share (EPS) figure.
Is There an Ideal Payout Ratio?
There is no single number that defines an ideal payout ratio because the adequacy largely depends on the sector in which a given company operates. Companies in defensive industries tend to boast stable earnings and cash flows that are able to support high payouts over the long haul while companies in cyclical industries typically make less reliable payouts, because their profits are vulnerable to macroeconomic fluctuations.
EPS is the portion of a company’s profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company’s profitability and is generally considered to be the single most important variable in determining a share’s price. It is also a major component of the P/E valuation ratio.
The total number of common shares currently owned by the public and available to be traded.
The float of a stock refers to the number of shares a company has issued for public trading.
A company’s stock float is calculated by subtracting the number of closely held and restricted shares from the number of total outstanding shares.
The number of floating stocks fluctuate over time and are influenced by various conditions in the market.
Investing in the stock market is always a risk, which is why it’s important to thoroughly research any company and its stock before making any decisions. One piece of information you’ll want to pay close attention to is float, which is the number of shares a public company has available for trading.
Here’s a closer look at what floating stock is all about and how it can help inform your investing strategies.
What is floating stock?
Floating stock is the number of public shares a company has available for trading on the open market. It’s not the total shares a company offers, as it excludes closely held and restricted stocks. A stock’s float just tells you how many shares can be bought or sold at the present time.
Calculating a company’s floating stock is a simple matter of subtracting the number of closely held and restricted shares from the number of total outstanding shares. Closely held shares may be owned by employees, major shareholders, or insiders, while restricted shares are ones that are not allowed to be traded for a certain period of time, such as during the lock-up period after an IPO.
Understanding how floating stocks work
Because floating stocks are the number of shares available to the public for trading, they’re subject to fluctuations over time and are influenced by various conditions. They are usually categorized as high and low.
High float: A stock float is considered high if it has a large number of shares available for trading. In the example above, Samsung Electronics Co., Ltd.’s float would be considered high because the vast majority of the total stock is open for trading.
It also means that it’s easier for investors to buy and sell these stocks because there isn’t a lot of demand. High floating stocks are preferred by institutional investors, such as mutual funds and insurance companies, because they can buy large numbers of shares without influencing the stock price much.
Low float: When a small percentage of shares are available for public trade, it’s considered a low float. This may be the result of having a large number of closely held or restricted shares or having few investors. The supply of shares is low, which can make them difficult to acquire and discourage investment.
A float may increase when a company issues new shares as a way to raise capital. It can also decrease if insiders or major shareholders buy up shares or increase if they sell shares.
“A company’s float is an important number for investors because it indicates how many shares are actually available to be bought and sold by the general investing public,” says Tim Speiss, co-partner in charge of the Personal Wealth Advisors Practice with EisnerAmper LLP. “Low float stocks typically have higher [bid-ask] spreads and higher volatility than a comparable larger float stock.”
What are low-float stocks?
While there’s no industry-wide standard for what defines low floating stocks, Speiss says, many brokers consider stocks with fewer than 10 million freely available shares for trading to be a low float.
For example, Nortech Systems Incorporated currently trades on the New York Stock Exchange with 2.66 million outstanding shares. Of that, 1.16 million shares are floating. Only about 44% of this stock is available for public trading. The majority of this stock is owned by either major investors, employees, or company insiders, making it a low float.
Smaller floats like this are subject to large swings in value from news impacting a company’s finances, popularity of products, and other changes that can influence demand. According to Nasdaq, Sequential Brands’ low float stock experienced a 104.57% increase in price between July 1 and 6, 2021 in spite of reports bankruptcy may be around the corner for the company. Trade volume spiked from nearly 34,000 shares on July 1 to around 13 million on July 6. Just two days later, the stock price dropped 27% and trading volume slowed to 728,000 shares.
This kind of volatility can present opportunities to buy and sell shares to quickly make money, but it isn’t generally compatible with long-term investment strategies. Because the value of low float stocks can be so unpredictable, there can be considerable risk attached to investing in them. Also, low float stocks are in short supply, which can make it difficult to buy or sell them. The bid-ask spread may be much higher than you would find with a high-float stock as a result.
As mentioned before, companies may decide to increase their float by issuing new shares as a way to raise capital or encourage more trading. But they may also choose to reduce their float through a stock buyback, which can result in increasing the value of shares. This usually happens if the company believes its shares have been discounted too much, wants to invest in itself, or wants to see its financial ratios go up.
“A stock buyback is a way for a company to reinvest in itself,” Speiss explains. “The repurchased shares are absorbed by the company and the number of outstanding shares in the market is reduced. Because there are fewer shares on the market post buyback, the relative ownership stake of each investor increases.”
Evaluating low-float stocks
A few things to keep in mind when considering investing in a low-float stock include:
Relative volume (RVOL): This is a comparison of how the current trading volume measures up against trading volume in a previous period. This indicator is key because it can impact a company’s liquidity and tells investors whether a company is worth investing in.
Reactions to news: Has the volume or price of a stock been impacted by news relating to the company that issues it? If so, what was that change and how long did it last? How often is the stock influenced by such news? Answers to these questions can give you an idea about past performance and inform your opinion about what may happen in the future.
Float percentage: This is the total number of shares available for trading, expressed as a percentage. When considering float percentage, ask yourself: How small is the float and how long has it been that size? Has the company recently instituted a stock repurchase? Was there a stock split or reverse split? Look for reasons why the float is low and if it has historically been so. This can give you insight as to whether there is a good opportunity to invest or if you should pass on the stock.
Shares outstanding
Shares outstanding is the total shares of stock a company has. It includes the restricted and closely held shares, as well as the ones available for trade, whereas float refers only to the number of shares available for trading.
It’s important to look at and understand how much the total stock is so you can calculate whether the float is high, low, or in the middle. You can find outstanding shares and float statistics on most investing websites and indexes. Subtract the float from the outstanding shares to find how many shares are not available for trading. That will help you better evaluate what kind of float a stock has and whether investing in it might fit into your overall strategy.
The financial takeaway
The term floating stock simply refers to the number of shares available right now for trading. It doesn’t include restricted or closely held stocks — only what you can buy and sell in the public market. You can use this statistic when you evaluate whether or not you want to invest in a particular stock.
Generally speaking, high-float stocks are usually best for long-term investing strategies. If you’re looking for potentially substantial gains in a short timeframe, then low float stocks can be something to look into. As with all investments, there are risks with both. Make sure to do your research and consult with a financial professional before making any money moves.
The number of shares short divided by total amount of shares float, expressed in %.
Short float is defined as the percentage of shares in the market that are shorted in relation to all shares in a float. Many active traders consider this percentage because it can indicate whether they can make a profit from trading a share. Beginners can also benefit from understanding short floats.
Nest Egg provides a quick guide to help beginner investors understand the significance of a short float and the information it provides about a share.
What is ‘float’?
Float refers to the total number or percentage of authorised shares that has already been made available in the share market for public trading.
There are different types of float shares and each one has conditions and rights attached. Nest Egg’s What are the different types of shares? explains the differences in further detail.
What is ‘shorting’?
Shorting refers to an investment strategy that involves borrowing shares from a broker and selling them for a profit then buying the same number of shares to return to the broker. However, the strategy isn’t as simple because shorting involves betting that a company’s share price will go down then borrowing the shares to sell at its current high price.
If the investor was correct and the share price declines, they would purchase the same number of shares at a lower price to return to their broker. This scenario would result in a profit once the investor closes their position.
However, if the share price increases and the broker calls for the investor to return the borrowed shares, the investor would have no choice but to purchase higher priced shares to close their position. This would result in loss for the investor.
What information does a short float reflect?
Short float shows the percentage of shares that are shorted relative to the number of float shares and this percentage reflects the market sentiment about the underlying company.
Since investors who short shares assume that the share price will decline, a high short percent of float implies that investors are either bearish on a company or they believe it is overvalued and they intend to profit off its potential decline by selling high.
How can beginners benefit from the short float information?
Beginner investors must learn that not all price movements are indicative of the underlying company’s performance simply because many experts are executing the trades. They have to be wary of the potential intent behind a price surge or decline before joining the bandwagon because they may end up being swept away by mere market sentiments.
Instead of blindly following a trend, beginners should consider searching for information regarding a company’s float shares and the proportion which is shorted—or those that were simply borrowed and sold. This percentage would give them the idea that a company may soon see a drop in their share price and that they could incur loss.
However, it’s also inadvisable to rely solely on the short float when making investment decisions because it is only one of the many metrics experts use.
Nest Egg recommends that investors practice due diligence before making an assumption and executing trades over a share’s price movement.
An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company’s annual earnings by its total assets, ROA is displayed as a percentage.
What Is Return on Assets (ROA)?
The term return on assets (ROA) refers to a financial ratio that indicates how profitable a company is in relation to its total assets. Corporate management, analysts, and investors can use ROA to determine how efficiently a company uses its assets to generate a profit.
The metric is commonly expressed as a percentage by using a company’s net income and its average assets. A higher ROA means a company is more efficient and productive at managing its balance sheet to generate profits while a lower ROA indicates there is room for improvement.
KEY TAKEAWAYS
Return on assets is a metric that indicates a company’s profitability in relation to its total assets.
ROA can be used by management, analysts, and investors to determine whether a company uses its assets efficiently to generate a profit.
You can calculate a company’s ROA by dividing its net income by its total assets.
It’s always best to compare the ROA of companies within the same industry because they’ll share the same asset base.
ROA factors in a company’s debt while return on equity does not.
eturn on Assets (ROA)
Businesses are about efficiency. Comparing profits to revenue is a useful operational metric, but comparing them to the resources a company used to earn them displays the feasibility of that company’s existence. Return on assets is the simplest of such corporate bang-for-the-buck measures. It tells you what earnings are generated from invested capital or assets.
ROA for public companies can vary substantially and are highly dependent on the industry in which they function so the ROA for a tech company won’t necessarily correspond to that of a food and beverage company. This is why when using ROA as a comparative measure, it is best to compare it against a company’s previous ROA numbers or a similar company’s ROA.
The ROA figure gives investors an idea of how effective the company is in converting the money it invests into net income. The higher the ROA number, the better, because the company is able to earn more money with a smaller investment. Put simply, a higher ROA means more asset efficiency.
ROA is calculated by dividing a company’s net income by its total assets. As a formula, it’s expressed as:
For example, pretend Sam and Milan both start hot dog stands. Sam spends $1,500 on a bare-bones metal cart, while Milan spends $15,000 on a zombie apocalypse-themed unit, complete with costume.
Let’s assume that those were the only assets each firm deployed. If over some given period, Sam earned $150 and Milan earned $1,200, Milan would have the more valuable business but Sam would have the more efficient one. Using the above formula, we see Sam’s simplified ROA is $150 / $1,500 = 10%, while Milan’s simplified ROA is $1,200/$15,000 = 8%.
Special Considerations
Because of the balance sheet accounting equation, note that total assets are also the sum of its total liabilities and shareholder equity. Both types of financing are used to fund a company’s operations. Since a company’s assets are either funded by debt or equity, some analysts and investors disregard the cost of acquiring the asset by adding back interest expense in the formula for ROA.
In other words, the impact of taking more debt is negated by adding back the cost of borrowing to the net income and using the average assets in a given period as the denominator. Interest expense is added because the net income amount on the income statement excludes interest expense.
ROA shouldn’t be the only determining factor when it comes to making your investment decisions. In fact, it’s just one of the many metrics available to evaluate a company’s profitability.
Return on Assets (ROA) vs. Return on Equity (ROE)
Both ROA and return on equity (ROE) measure how well a company utilizes its resources. But one of the key differences between the two is how they each treat a company’s debt. ROA factors in how leveraged a company is or how much debt it carries. After all, its total assets include any capital it borrows to run its operations.
On the other hand, ROE only measures the return on a company’s equity, which leaves out its liabilities. Thus, ROA accounts for a company’s debt and ROE does not. The more leverage and debt a company takes on, the higher ROE will be relative to ROA. Thus, as a company takes on more debt, its ROE would be higher than its ROA.
Assuming returns are constant, assets are now higher than equity and the denominator of the return on assets calculation is higher because assets are higher. This means that a company’s ROA falls while its ROE stays at its previous level.
Limitations of ROA
As noted above, one of the biggest issues with ROA is that it can’t be used across industries. That’s because companies in one industry have different asset bases than those in another. So the asset bases of companies within the oil and gas industry aren’t the same as those in the retail industry.
Some analysts also feel that the basic ROA formula is limited in its applications, being most suitable for banks. Bank balance sheets better represent the real value of their assets and liabilities because they’re carried at market value via mark-to-market accounting (or at least an estimate of market value) versus historical cost. Both interest expense and interest income are already factored into the equation.
For non-financial companies, debt and equity capital are strictly segregated, as are the returns to each:
Interest expense is the return for debt providers
Net income is the return for equity investors
So the common ROA formula jumbles things up by comparing returns to equity investors (net income) with assets funded by both debt and equity investors (total assets). Two variations on this ROA formula fix this numerator-denominator inconsistency by putting interest expense (net of taxes) back into the numerator. So the formulas would be:
ROA Variation 1: Net Income + [Interest Expense x (1 – Tax Rate)] / Total Assets
ROA Variation 2: Operating Income x (1 – Tax Rate) / Total Assets
The St. Louis Federal Reserve provided data on U.S. bank ROAs, which generally hovered under 1.4% between 1984 and 2020 when it was discontinued.1
Example of ROA
Remember that ROA is most useful for comparing companies in the same industry, as different industries use assets differently. For example, the ROA for service-oriented firms, such as banks, will be significantly higher than the ROA for capital-intensive companies, such as construction or utility companies.
Let’s evaluate the ROA for three companies in the retail industry:
Macy’s (M)
Kohl’s (KSS)
Dillard’s (DDS)
The data in the table is for the trailing 12 months (TTM) as of Feb. 13, 2019.
Retail Sector Stocks
Company
Net Income
Total Assets
ROA
Macy’s
$1.7 billion
$20.4 billion
8.3%
Kohl’s
$996 million
$14.1 billion
7.1%
Dillard’s
$243 million
$3.9 billion
6.2%
Every dollar that Macy’s invested in assets generated 8.3 cents of net income. Macy’s was better at converting its investment into profits, compared with Kohl’s and Dillard’s. One of management’s most important jobs is to make wise choices in allocating its resources, and it appears Macy’s management, in the reported period, was more adept than its two peers.
How Is ROA Used by Investors?
Investors can use ROA to find stock opportunities because the ROA shows how efficient a company is at using its assets to generate profits.
A ROA that rises over time indicates the company is doing well at increasing its profits with each investment dollar it spends. A falling ROA indicates the company might have over-invested in assets that have failed to produce revenue growth, a sign the company may be in some trouble. ROA can also be used to make apples-to-apples comparisons across companies in the same sector or industry.
How Can I Calculate a Company’s ROA?
ROA is calculated by dividing a firm’s net income by the average of its total assets. It is then expressed as a percentage.
Net profit can be found at the bottom of a company’s income statement, and assets are found on its balance sheet. Average total assets are used in calculating ROA because a company’s asset total can vary over time due to the purchase or sale of vehicles, land, equipment, inventory changes, or seasonal sales fluctuations. As a result, calculating the average total assets for the period in question is more accurate than the total assets for one period.
What Is Considered a Good ROA?
A ROA of over 5% is generally considered good and over 20% excellent. However, ROAs should always be compared amongst firms in the same sector. For instance, a software maker has far fewer assets on the balance sheet than a car maker. As a result, the software company’s assets will be understated and its ROA may get a questionable boost.
A measure of a corporation’s profitability that reveals how much profit a company generates with the money shareholders have invested. Calculated as Net Income / Shareholder’s Equity.
What Is Return on Equity (ROE)?
Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets.
ROE is considered a gauge of a corporation’s profitability and how efficient it is in generating profits. The higher the ROE, the more efficient a company’s management is at generating income and growth from its equity financing.
KEY TAKEAWAYS
Return on equity (ROE) is the measure of a company’s net income divided by its shareholders’ equity.
ROE is a gauge of a corporation’s profitability and how efficiently it generates those profits.
The higher the ROE, the better a company is at converting its equity financing into profits.
To calculate ROE, divide net income by the value of shareholders’ equity.
ROEs will vary based on the industry or sector in which the company operates.
ROE is expressed as a percentage and can be calculated for any company if net income and equity are both positive numbers. Net income is calculated before dividends paid to common shareholders and after dividends to preferred shareholders and interest to lenders.
\begin{aligned} &\text{Return on Equity} = \dfrac{\text{Net Income}}{\text{Average Shareholders’ Equity}}\\ \end{aligned}Return on Equity=Average Shareholders’ EquityNet Income
Net income is the amount of income, net expenses, and taxes that a company generates for a given period. Average shareholders’ equity is calculated by adding equity at the beginning of the period. The beginning and end of the period should coincide with the period during which the net income is earned.
Net income over the last full fiscal year, or trailing 12 months, is found on the income statement—a sum of financial activity over that period. Shareholders’ equity comes from the balance sheet—a running balance of a company’s entire history of changes in assets and liabilities.
It is considered best practice to calculate ROE based on average equity over a period because of the mismatch between the income statement and the balance sheet.
What Return on Equity Tells You
Whether an ROE is deemed good or bad will depend on what is normal among a stock’s peers. For example, utilities have many assets and debt on the balance sheet compared to a relatively small amount of net income. A normal ROE in the utility sector could be 10% or less. A technology or retail firm with smaller balance sheet accounts relative to net income may have normal ROE levels of 18% or more.
A good rule of thumb is to target an ROE that is equal to or just above the average for the company’s sector—those in the same business. For example, assume a company, TechCo, has maintained a steady ROE of 18% over the past few years compared to the average of its peers, which was 15%. An investor could conclude that TechCo’s management is above average at using the company’s assets to create profits.
Relatively high or low ROE ratios will vary significantly from one industry group or sector to another. Still, a common shortcut for investors is to consider a return on equity near the long-term average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.
Return on Equity and Stock Performance
Sustainable growth rates and dividend growth rates can be estimated using ROE, assuming that the ratio is roughly in line or just above its peer group average. Although there may be some challenges, ROE can be a good starting place for developing future estimates of a stock’s growth rate and the growth rate of its dividends. These two calculations are functions of each other and can be used to make an easier comparison between similar companies.
To estimate a company’s future growth rate, multiply the ROE by the company’s retention ratio. The retention ratio is the percentage of net income that is retained or reinvested by the company to fund future growth.
21.88%
Companies in the S&P 500 saw an average ROE of 21.88% in 2021.1
ROE and a Sustainable Growth Rate
Assume that there are two companies with identical ROEs and net income but different retention ratios. This means they will each have a different sustainable growth rate (SGR). The SGR is the rate a company can grow without having to borrow money to finance that growth. The formula for calculating SGR is ROE times the retention ratio (or ROE times one minus the payout ratio).
For example, Company A has an ROE of 15% and has a retention ratio of 70%. Business B also has an ROE of 15% but has a 90% retention ratio. For Company A, the sustainable growth rate is 10.5% (15% * 70%). Business B’s SGR is 13.5% (15% * 90%).
A stock that is growing at a slower rate than its sustainable rate could be undervalued, or the market may be accounting for key risks. In either case, a growth rate that is far above or below the sustainable rate warrants additional investigation.
Using Return on Equity to Identify Problems
It’s reasonable to wonder why an average or slightly above-average ROE is preferable rather than an ROE that is double, triple, or even higher than the average of its peer group. Aren’t stocks with a very high ROE a better value?
Sometimes an extremely high ROE is a good thing if net income is extremely large compared to equity because a company’s performance is so strong. However, an extremely high ROE is often due to a small equity account compared to net income, which indicates risk.
Inconsistent Profits
The first potential issue with a high ROE could be inconsistent profits. Imagine that a company, LossCo, has been unprofitable for several years. Each year’s losses are recorded on the balance sheet in the equity portion as a “retained loss.” These losses are a negative value and reduce shareholders’ equity.
Now, assume that LossCo has had a windfall in the most recent year and has returned to profitability. The denominator in the ROE calculation is now very small after many years of losses, which makes its ROE misleadingly high.
Excess Debt
A second issue that could cause a high ROE is excess debt. If a company has been borrowing aggressively, it can increase ROE because equity is equal to assets minus debt. The more debt a company has, the lower equity can fall. A common scenario is when a company borrows large amounts of debt to buy back its own stock. This can inflate earnings per share (EPS), but it does not affect actual performance or growth rates.
Negative Net Income
Finally, negative net income and negative shareholders’ equity can create an artificially high ROE. However, if a company has a net loss or negative shareholders’ equity, ROE should not be calculated.
If shareholders’ equity is negative, the most common issue is excessive debt or inconsistent profitability. However, there are exceptions to that rule for companies that are profitable and have been using cash flow to buy back their own shares. For many companies, this is an alternative to paying dividends, and it can eventually reduce equity (buybacks are subtracted from equity) enough to turn the calculation negative.
In all cases, negative or extremely high ROE levels should be considered a warning sign worth investigating. In rare cases, a negative ROE ratio could be due to a cash flow-supported share buyback program and excellent management, but this is the less likely outcome. In any case, a company with a negative ROE cannot be evaluated against other stocks with positive ROE ratios.
Limitations of Return on Equity
A high ROE might not always be positive. An outsize ROE can be indicative of a number of issues—such as inconsistent profits or excessive debt. Also, a negative ROE due to the company having a net loss or negative shareholders’ equity cannot be used to analyze the company, nor can it be used to compare against companies with a positive ROE.
As with all tools used for investment analysis, ROE is just one of many available metrics that identifies just one portion of a firm’s overall financials. It is crucial to utilize a combination of financial metrics to get a full understanding of a company’s financial health before investing.
Return on Equity vs. Return on Invested Capital
Though ROE looks at how much profit a company can generate relative to shareholders’ equity, return on invested capital (ROIC) takes that calculation a couple of steps further.
The purpose of ROIC is to figure out the amount of money after dividends a company makes based on all its sources of capital, which includes shareholders’ equity and debt. ROE looks at how well a company uses shareholders’ equity while ROIC is meant to determine how well a company uses all its available capital to make money.
Example of Return on Equity
For example, imagine a company with an annual income of $1,800,000 and average shareholders’ equity of $12,000,000. This company’s ROE would be 15%, or $1.8 million divided by $12 million.
As a real-world example, consider Apple Inc. (AAPL)’s financials for the fiscal year ending Sept. 29, 2018, the company generated $59.5 billion in net income. At the end of the fiscal year, its shareholders’ equity was $107.1 billion versus $134 billion at the beginning.2
Apple’s return on equity, therefore, is 49.4%, or $59.5 billion / [($107.1 billion + $134 billion) / 2].
Compared to its peers, Apple had a very strong ROE:
Amazon.com, Inc. (AMZN) had an ROE of 28.3% in 2018.3
Microsoft Corp. (MSFT) had an ROE of 19.4% in 2018.4
Google (GOOGL) had an ROE of 18.6% for 2018.5
How to Calculate ROE Using Excel
The formula for calculating a company’s ROE is its net income divided by shareholders’ equity. Here’s how to use Microsoft Excel to set up the calculation for ROE:
In Excel, get started by right-clicking on column A. Next, move the cursor down and left-click on column width. Then, change the column width value to 30 default units and click OK. Repeat this procedure for columns B and C.
Next, enter the name of a company into cell B1 and the name of another company into cell C1.
Then, enter “Net Income” into cell A2, “Shareholders’ Equity” into cell A3, and “Return on Equity” into cell A4.
Enter the formula for “Return on Equity” =B2/B3 into cell B4 and enter the formula =C2/C3 into cell C4.
When that is complete, enter the corresponding values for “Net Income” and “Shareholders’ Equity” into cells B2, B3, C2, and C3.
ROE and DuPont Analysis
Though ROE can easily be computed by dividing net income by shareholders’ equity, a technique called DuPont decomposition can break down the ROE calculation into additional steps. Created by the American chemicals corporation DuPont in the 1920s, this analysis reveals which factors are contributing the most (or the least) to a firm’s ROE.
There are two versions of DuPont analysis. The first involves three steps:
\begin{aligned} &\text{ROE} = \text{NPM} \times \text{Asset Turnover} \times \text{Equity Multiplier} \\ &\textbf{where:} \\ &\text{NPM} = \text{Net profit margin, the measure of operating} \\ &\text{efficiency} \\ &\text{Asset Turnover} = \text{Measure of asset use efficiency} \\ &\text{Equity Multiplier} = \text{Measure of financial leverage} \\ \end{aligned}ROE=NPM×Asset Turnover×Equity Multiplierwhere:NPM=Net profit margin, the measure of operatingefficiencyAsset Turnover=Measure of asset use efficiencyEquity Multiplier=Measure of financial leverage
Alternatively, the five-step version is as follows:
Both the three- and five-step equations provide a deeper understanding of a company’s ROE by examining what is changing in a company rather than looking at one simple ratio. As always with financial statement ratios, they should be examined against the company’s history and its competitors’ histories.
For example, when looking at two peer companies, one may have a lower ROE. With the five-step equation, you can see if this is lower because creditors perceive the company as riskier and charge it higher interest, the company is poorly managed and has leverage that is too low, or the company has higher costs that decrease its operating profit margin. Identifying sources like these leads to a better knowledge of the company and how it should be valued.
What Is a Good ROE?
As with most other performance metrics, what counts as a “good” ROE will depend on the company’s industry and competitors. Though the long-term ROE for S&P 500 companies has averaged around 18.6%, specific industries can be significantly higher or lower.6 All else being equal, an industry will likely have a lower average ROE if it is highly competitive and requires substantial assets in order to generate revenues. On the other hand, industries with relatively few players and where only limited assets are needed to generate revenues may show a higher average ROE.
How Do You Calculate ROE?
To calculate ROE, analysts simply divide the company’s net income by its average shareholders’ equity. Because shareholders’ equity is equal to assets minus liabilities, ROE is essentially a measure of the return generated on the net assets of the company. Since the equity figure can fluctuate during the accounting period in question, an average shareholders’ equity is used.
What Is the Difference Between Return on Assets (ROA) and ROE?
Return on assets (ROA) and ROE are similar in that they are both trying to gauge how efficiently the company generates its profits. However, whereas ROE compares net income to the net assets of the company, ROA compares net income to the company’s assets alone, without deducting its liabilities. In both cases, companies in industries in which operations require significant assets will likely show a lower average return.
What Happens if ROE Is Negative?
If a company’s ROE is negative, it means that there was negative net income for the period in question (i.e., a loss). This implies that shareholders are losing on their investment in the company. For new and growing companies, a negative ROE is often to be expected; however, if negative ROE persists it can be a sign of trouble.
What Causes ROE to Increase?
ROE will increase as net income increases, all else equal. Another way to boost ROE is to reduce the value of shareholders’ equity. Since equity is equal to assets minus liabilities, increasing liabilities (e.g., taking on more debt financing) is one way to artificially boost ROE without necessarily increasing profitability. This can be amplified if that debt is used to engage in share buybacks, effectively reducing the amount of equity available.
Performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment.
What Is Return on Investment (ROI)?
Return on investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.
To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.
KEY TAKEAWAYS
Return on Investment (ROI) is a popular profitability metric used to evaluate how well an investment has performed.
ROI is expressed as a percentage and is calculated by dividing an investment’s net profit (or loss) by its initial cost or outlay.
ROI can be used to make apples-to-apples comparisons and rank investments in different projects or assets.
ROI does not take into account the holding period or passage of time, and so it can miss opportunity costs of investing elsewhere.
Whether or not something delivers a good ROI should be compared relative to other available opportunities.
How to Calculate Return on Investment (ROI)
The return on investment (ROI) formula is as follows:
\begin{aligned} &\text{ROI} = \dfrac{\text{Current Value of Investment}-\text{Cost of Investment}}{\text{Cost of Investment}}\\ \end{aligned}ROI=Cost of InvestmentCurrent Value of Investment−Cost of Investment
“Current Value of Investment” refers to the proceeds obtained from the sale of the investment of interest. Because ROI is measured as a percentage, it can be easily compared with returns from other investments, allowing one to measure a variety of types of investments against one another.
Understanding ROI
ROI is a popular metric because of its versatility and simplicity. Essentially, ROI can be used as a rudimentary gauge of an investment’s profitability. This could be the ROI on a stock investment, the ROI a company expects on expanding a factory, or the ROI generated in a real estate transaction.
The calculation itself is not too complicated, and it is relatively easy to interpret for its wide range of applications. If an investment’s ROI is net positive, it is probably worthwhile. But if other opportunities with higher ROIs are available, these signals can help investors eliminate or select the best options. Likewise, investors should avoid negative ROIs, which imply a net loss.
For example, suppose Jo invested $1,000 in Slice Pizza Corp. in 2017 and sold the shares for a total of $1,200 one year later. To calculate the return on this investment, divide the net profits ($1,200 – $1,000 = $200) by the investment cost ($1,000), for an ROI of $200/$1,000, or 20%.
With this information, one could compare the investment in Slice Pizza with any other projects. Suppose Jo also invested $2,000 in Big-Sale Stores Inc. in 2014 and sold the shares for a total of $2,800 in 2017. The ROI on Jo’s holdings in Big-Sale would be $800/$2,000, or 40%.
Limitations of ROI
Examples like Jo’s (above) reveal some limitations of using ROI, particularly when comparing investments. While the ROI of Jo’s second investment was twice that of the first investment, the time between Jo’s purchase and the sale was one year for the first investment but three years for the second.
Jo could adjust the ROI of the multi-year investment accordingly. Since the total ROI was 40%, to obtain the average annual ROI, Jo could divide 40% by 3 to yield 13.33% annualized. With this adjustment, it appears that although Jo’s second investment earned more profit, the first investment was actually the more efficient choice.
ROI can be used in conjunction with the rate of return (RoR), which takes into account a project’s time frame. One may also use net present value (NPV), which accounts for differences in the value of money over time, due to inflation. The application of NPV when calculating the RoR is often called the real rate of return.
Developments in ROI
Recently, certain investors and businesses have taken an interest in the development of new forms of ROIs, called “social return on investment,” or SROI. SROI was initially developed in the late 1990s and takes into account broader impacts of projects using extra-financial value (i.e., social and environmental metrics not currently reflected in conventional financial accounts).1
SROI helps understand the value proposition of certain environmental social and governance (ESG) criteria used in socially responsible investing (SRI) practices.1 For instance, a company may decide to recycle water in its factories and replace its lighting with all LED bulbs. These undertakings have an immediate cost that may negatively impact traditional ROI—however, the net benefit to society and the environment could lead to a positive SROI.
There are several other new variations of ROIs that have been developed for particular purposes. Social media statistics ROI pinpoints the effectiveness of social media campaigns—for example how many clicks or likes are generated for a unit of effort. Similarly, marketing statistics ROI tries to identify the return attributable to advertising or marketing campaigns.
So-called learning ROI relates to the amount of information learned and retained as a return on education or skills training. As the world progresses and the economy changes, several other niche forms of ROI are sure to be developed in the future.
What Is ROI in Simple Terms?
Basically, return on investment (ROI) tells you how much money you’ve made (or lost) an investment or project after accounting for its cost.
How Do You Calculate Return on Investment (ROI)?
Return on investment (ROI) is calculated by dividing the profit earned on an investment by the cost of that investment. For instance, an investment with a profit of $100 and a cost of $100 would have an ROI of 1, or 100% when expressed as a percentage. Although ROI is a quick and easy way to estimate the success of an investment, it has some serious limitations. For instance, ROI fails to reflect the time value of money, and it can be difficult to meaningfully compare ROIs because some investments will take longer to generate a profit than others. For this reason, professional investors tend to use other metrics, such as net present value (NPV) or the internal rate of return (IRR).
What Is a Good ROI?
What qualifies as a “good” ROI will depend on factors such as the risk tolerance of the investor and the time required for the investment to generate a return. All else being equal, investors who are more risk-averse will likely accept lower ROIs in exchange for taking less risk. Likewise, investments that take longer to pay off will generally require a higher ROI in order to be attractive to investors.
What Industries Have the Highest ROI?
Historically, the average ROI for the S&P 500 has been about 10% per year.2 Within that, though, there can be considerable variation depending on the industry. For instance, during 2020, many technology companies generated annual returns well above this 10% threshold. Meanwhile, companies in other industries, such as energy companies and utilities, generated much lower ROIs and in some cases faced losses year-over-year.3 Over time, it is normal for the average ROI of an industry to shift due to factors such as increased competition, technological changes, and shifts in consumer preferences.
A liquidity ratio that measures a company’s ability to pay short-term obligations. Calculated as Current Assets / Current Liabilities.
What Is the Current Ratio?
The current ratio is a liquidity ratio that measures a company’s ability to pay short-term obligations or those due within one year. It tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables.
A current ratio that is in line with the industry average or slightly higher is generally considered acceptable. A current ratio that is lower than the industry average may indicate a higher risk of distress or default. Similarly, if a company has a very high current ratio compared with its peer group, it indicates that management may not be using its assets efficiently.
The current ratio is called current because, unlike some other liquidity ratios, it incorporates all current assets and current liabilities. The current ratio is sometimes called the working capital ratio.
KEY TAKEAWAYS
The current ratio compares all of a company’s current assets to its current liabilities.
These are usually defined as assets that are cash or will be turned into cash in a year or less and liabilities that will be paid in a year or less.
The current ratio helps investors understand more about a company’s ability to cover its short-term debt with its current assets and make apples-to-apples comparisons with its competitors and peers.
One weakness of the current ratio is its difficulty of comparing the measure across industry groups.
Others include the overgeneralization of the specific asset and liability balances, and the lack of trending information.
Formula and Calculation for the Current Ratio
To calculate the ratio, analysts compare a company’s current assets to its current liabilities.1
Current assets listed on a company’s balance sheet include cash, accounts receivable, inventory, and other current assets (OCA) that are expected to be liquidated or turned into cash in less than one year.
Current liabilities include accounts payable, wages, taxes payable, short-term debts, and the current portion of long-term debt.
The current ratio measures a company’s ability to pay current, or short-term, liabilities (debts and payables) with its current, or short-term, assets, such as cash, inventory, and receivables.
In many cases, a company with a current ratio of less than 1.00 does not have the capital on hand to meet its short-term obligations if they were all due at once, while a current ratio greater than 1.00 indicates that the company has the financial resources to remain solvent in the short term. However, because the current ratio at any one time is just a snapshot, it is usually not a complete representation of a company’s short-term liquidity or longer-term solvency.
For example, a company may have a very high current ratio, but its accounts receivable may be very aged, perhaps because its customers pay slowly, which may be hidden in the current ratio. Some of the accounts receivable may even need to be written off. Analysts also must consider the quality of a company’s other assets vs. its obligations. If the inventory is unable to be sold, the current ratio may still look acceptable at one point in time, even though the company may be headed for default.
Interpreting the Current Ratio
A ratio under 1.00 indicates that the company’s debts due in a year or less are greater than its assets—cash or other short-term assets expected to be converted to cash within a year or less. A current ratio of less than 1.00 may seem alarming, although different situations can negatively affect the current ratio in a solid company.
For example, a normal cycle for the company’s collections and payment processes may lead to a high current ratio as payments are received, but a low current ratio as those collections ebb. Calculating the current ratio at just one point in time could indicate that the company can’t cover all of its current debts, but it doesn’t necessarily mean that it won’t be able to when the payments are due.
Additionally, some companies, especially larger retailers such as Walmart, have been able to negotiate much longer-than-average payment terms with their suppliers. If a retailer doesn’t offer credit to its customers, this can show on its balance sheet as a high payables balance relative to its receivables balance. Large retailers can also minimize their inventory volume through an efficient supply chain, which makes their current assets shrink against current liabilities, resulting in a lower current ratio. Walmart’s current ratio as of July 2021 was 0.96.23
In theory, the higher the current ratio, the more capable a company is of paying its obligations because it has a larger proportion of short-term asset value relative to the value of its short-term liabilities. However, though a high ratio—say, more than 3.00—could indicate that the company can cover its current liabilities three times, it also may indicate that it is not using its current assets efficiently, securing financing very well, or properly managing its working capital.
The current ratio can be a useful measure of a company’s short-term solvency when it is placed in the context of what has been historically normal for the company and its peer group. It also offers more insight when calculated repeatedly over several periods.
How the Current Ratio Changes Over Time
What makes the current ratio good or bad often depends on how it is changing. A company that seems to have an acceptable current ratio could be trending toward a situation in which it will struggle to pay its bills. Conversely, a company that may appear to be struggling now could be making good progress toward a healthier current ratio.
In the first case, the trend of the current ratio over time would be expected to harm the company’s valuation. Meanwhile, an improving current ratio could indicate an opportunity to invest in an undervalued stock amid a turnaround.
Imagine two companies with a current ratio of 1.00 today. Based on the trend of the current ratio in the following table, for which would analysts likely have more optimistic expectations?
Two things should be apparent in the trend of Horn & Co. vs. Claws Inc. First, the trend for Claws is negative, which means further investigation is prudent. Perhaps it is taking on too much debt or its cash balance is being depleted—either of which could be a solvency issue if it worsens. The trend for Horn & Co. is positive, which could indicate better collections, faster inventory turnover, or that the company has been able to pay down debt.
The second factor is that Claws’ current ratio has been more volatile, jumping from 1.35 to 1.05 in a single year, which could indicate increased operational risk and a likely drag on the company’s value.
Example Using the Current Ratio
The current ratios of three companies—Apple, Walt Disney, and Costco Wholesale—are calculated as follows for the fiscal year ended 2017:
For every $1 of current debt, Costco Wholesale had 99 cents available to pay for debt when this snapshot was taken.4 Likewise, Walt Disney had 81 cents in current assets for each dollar of current debt.5 Apple, meanwhile, had more than enough to cover its current liabilities if they were all theoretically due immediately and all current assets could be turned into cash.6
Current Ratio vs. Other Liquidity Ratios
Other similar liquidity ratios can supplement a current ratio analysis. In each case, the differences in these measures can help an investor understand the current status of the company’s assets and liabilities from different angles, as well as how those accounts are changing over time.
The commonly used acid-test ratio, or quick ratio, compares a company’s easily liquidated assets (including cash, accounts receivable, and short-term investments, excluding inventory and prepaid expenses) to its current liabilities. The cash asset ratio, or cash ratio, also is similar to the current ratio, but it only compares a company’s marketable securities and cash to its current liabilities.
Finally, the operating cash flow ratio compares a company’s active cash flow from operating activities (CFO) to its current liabilities.
Limitations of Using the Current Ratio
One limitation of the current ratio emerges when using it to compare different companies with one another. Businesses differ substantially among industries; comparing the current ratios of companies across different industries may not lead to productive insight.
For example, in one industry, it may be more typical to extend credit to clients for 90 days or longer, while in another industry, short-term collections are more critical. Ironically, the industry that extends more credit actually may have a superficially stronger current ratio because its current assets would be higher. It is usually more useful to compare companies within the same industry.
Another drawback of using the current ratio, briefly mentioned above, involves its lack of specificity. Unlike many other liquidity ratios, it incorporates all of a company’s current assets, even those that cannot be easily liquidated. For example, imagine two companies that both have a current ratio of 0.80 at the end of the last quarter. On the surface, this may look equivalent, but the quality and liquidity of those assets may be very different, as shown in the following breakdown:
In this example, Company A has much more inventory than Company B, which will be harder to turn into cash in the short term. Perhaps this inventory is overstocked or unwanted, which eventually may reduce its value on the balance sheet. Company B has more cash, which is the most liquid asset, and more accounts receivable, which could be collected more quickly than liquidating inventory. Although the total value of current assets matches, Company B is in a more liquid, solvent position.
The current liabilities of Company A and Company B are also very different. Company A has more accounts payable, while Company B has a greater amount in short-term notes payable. This would be worth more investigation because it is likely that the accounts payable will have to be paid before the entire balance of the notes-payable account. Company A also has fewer wages payable, which is the liability most likely to be paid in the short term.
In this example, although both companies seem similar, Company B is likely in a more liquid and solvent position. An investor can dig deeper into the details of a current ratio comparison by evaluating other liquidity ratios that are more narrowly focused than the current ratio.
What Is a Good Current Ratio?
What counts as a good current ratio will depend on the company’s industry and historical performance. Current ratios of 1.50 or greater would generally indicate ample liquidity. Publicly listed companies in the United States reported a median current ratio of 1.94 in 2020.7
What Happens If the Current Ratio Is Less Than 1?
As a general rule, a current ratio below 1.00 could indicate that a company might struggle to meet its short-term obligations, whereas ratios of
What Does a Current Ratio of 1.5 Mean?
A current ratio of 1.5 would indicate that the company has $1.50 of current assets for every $1 of current liabilities. For example, suppose a company’s current assets consist of $50,000 in cash plus $100,000 in accounts receivable. Its current liabilities, meanwhile, consist of $100,000 in accounts payable. In this scenario, the company would have a current ratio of 1.5, calculated by dividing its current assets ($150,000) by its current liabilities ($100,000).
How Is the Current Ratio Calculated?
Calculating the current ratio is very straightforward: Simply divide the company’s current assets by its current liabilities. Current assets are those that can be converted into cash within one year, while current liabilities are obligations expected to be paid within one year. Examples of current assets include cash, inventory, and accounts receivable. Examples of current liabilities include accounts payable, wages payable, and the current portion of any scheduled interest or principal payments.
An indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the position of the company. Calculated as (Current Assets – Inventories) / Current Liabilities.
What Is the Quick Ratio?
The quick ratio is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets.
Since it indicates the company’s ability to instantly use its near-cash assets (assets that can be converted quickly to cash) to pay down its current liabilities, it is also called the acid test ratio. An “acid test” is a slang term for a quick test designed to produce instant results.
KEY TAKEAWAYS
The quick ratio measures a company’s capacity to pay its current liabilities without needing to sell its inventory or obtain additional financing.
The quick ratio is considered a more conservative measure than the current ratio, which includes all current assets as coverage for current liabilities.
The quick ratio is calculated by dividing a company’s most liquid assets like cash, cash equivalents, marketable securities, and accounts receivables by total current liabilities.
Specific current assets such as prepaids and inventory are excluded as those may not be as easily convertible to cash or may require substantial discounts to liquidate.
The higher the ratio result, the better a company’s liquidity and financial health; the lower the ratio, the more likely the company will struggle with paying debts.
What Is The Quick Ratio?
Understanding the Quick Ratio
The quick ratio measures the dollar amount of liquid assets available against the dollar amount of current liabilities of a company. Liquid assets are those current assets that can be quickly converted into cash with minimal impact on the price received in the open market, while current liabilities are a company’s debts or obligations that are due to be paid to creditors within one year.
A result of 1 is considered to be the normal quick ratio. It indicates that the company is fully equipped with exactly enough assets to be instantly liquidated to pay off its current liabilities. A company that has a quick ratio of less than 1 may not be able to fully pay off its current liabilities in the short term, while a company having a quick ratio higher than 1 can instantly get rid of its current liabilities. For instance, a quick ratio of 1.5 indicates that a company has $1.50 of liquid assets available to cover each $1 of its current liabilities.
While such numbers-based ratios offer insight into the viability and certain aspects of a business, they may not provide a complete picture of the overall health of the business. It is important to look at other associated measures to assess the true picture of a company’s financial health.
The higher the quick ratio, the better a company’s liquidity and financial health, but it important to look at other related measures to assess the whole picture of a company’s financial health.
Formula for the Quick Ratio
There’s a few different ways to calculate the quick ratio. The most common approach is to add the most liquid assets and divide the total by current liabilities:
Quick Ratio = “Quick Assets” / Current Liabilities
Quick assets are defined as the most liquid current assets that can easily be exchanged for cash. For most companies, quick assets are limited to just a few types of assets:
Depending on what type of current assets a company has on its balance sheet, a company may also calculate quick assets by deducting illiquid current assets from its balance sheet. For example, consider that inventory and prepaid expenses may not be easily or quickly converted to cash, a company may calculate quick assets as follows:
Quick Assets = Total Current Assets – Inventory – Prepaid Expenses
Regardless of which method is used to calculate quick assets, the calculation for current liabilities is the same as all current liabilities are included in the formula.
Components of the Quick Ratio
Cash
Cash is among the more straight-forward pieces of the quick ratio. A company should strive to reconcile their cash balance to monthly bank statements received from their financial institutions. This cash component may include cash from foreign countries translated to a single denomination.
Cash Equivalents
Cash equivalents are often an extension of cash as this account often houses investments with very low risk and high liquidity. Cash equivalents often include but may not necessarily be limited to Treasury bills, certificates of deposits (being mindful of options/fees to break the CD), bankers’ acceptances, corporate commercial paper, or other money market instruments.
In publication by the American Institute of Certified Public Accountants (AICPA), digital assets such as cryptocurrency or digital tokens may not be reported as cash or cash equivalents.1
Marketable Securities
Marketable securities, are usually free from such time-bound dependencies. However, to maintain precision in the calculation, one should consider only the amount to be actually received in 90 days or less under normal terms. Early liquidation or premature withdrawal of assets like interest-bearing securities may lead to penalties or discounted book value.
Net Accounts Receivable
Whether accounts receivable is a source of quick, ready cash remains a debatable topic, and depends on the credit terms that the company extends to its customers. A company that needs advance payments or allows only 30 days to the customers for payment will be in a better liquidity position than a company that gives 90 days.
On the other hand, a company could negotiate rapid receipt of payments from its customers and secure longer terms of payment from its suppliers, which would keep liabilities on the books longer. By converting accounts receivable to cash faster, it may have a healthier quick ratio and be fully equipped to pay off its current liabilities.
The total accounts receivable balance should be reduced by the estimated amount of uncollectible receivables. As the quick ratio only wants to reflect the cash that could be on hand, the formula should not include any receivables a company does not expect to receive.
Current Liabilities
The quick ratio pulls all current liabilities from a company’s balance sheet as it does not attempt to distinguish between when payments may be due. The quick ratio assumes that all current liabilities have a near-term due date. Total current liabilities are often calculated as the sum of various accounts including accounts payable, wages payable, current portions of long-term debt, and taxes payable.
Because prepaid expenses may not be refundable and inventory may be difficult to quickly convert to cash without severe product discounts, both are excluded from the asset portion of the quick ratio.
Quick Ratio vs. Current Ratio
The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are generally more difficult to turn into cash. The quick ratio considers only assets that can be converted to cash in a short period of time. The current ratio, on the other hand, considers inventory and prepaid expense assets. In most companies, inventory takes time to liquidate, although a few rare companies can turn their inventory fast enough to consider it a quick asset. Prepaid expenses, though an asset, cannot be used to pay for current liabilities, so they’re omitted from the quick ratio.
Advantages and Limitations of Quick Ratio
The quick ratio has the advantage of being a more conservative estimate of how liquid a company is. Compared to other calculations that include potentially illiquid assets, the quick ratio is often a better true indicator of short-term cash capabilities.
The quick ratio is also fairly easy and straightforward to calculate. It’s relatively easy to understand, especially when comparing a company’s liquidity against a target calculation such as 1.0. The quick ratio can be used to analyze a single company over a period of time or can be used to compare similar companies.
There are several downsides to the quick ratio. The financial metric does not give any indication about a company’s future cash flow activity. Though a company may be sitting on $1 million today, the company may not be selling a profitable good and may struggle to maintain its cash balance in the future. There are also considerations to make regarding the true liquidity of accounts receivable as well as marketable securities in some situations.
Quick Ratio
Pros
Conservative approach on estimating a company’s liquidity
Relatively straightforward to calculate
All components are reported on a company’s balance sheet
Can be used to compare companies across time periods or sectors
Cons
Does not consider future cash flow capabilities of the company
Does not consider long-term liabilities (some of which may be due as early as 12 months from now)
May overstate the true collectability of accounts receivable
May overstate the true liquidity of marketable securities during economic downturns
Example of Quick Ratio
Publicly traded companies generally report the quick ratio figure under the “Liquidity/Financial Health” heading in the “Key Ratios” section of their quarterly reports.
Below is the calculation of the quick ratio based on the figures that appear on the balance sheets of two leading competitors operating in the personal care industrial sector, P&G and J&J, for the fiscal year ending in 2021.23
(in $millions)
Procter & Gamble
Johnson & Johnson
Quick Assets (A)
$15,013
$46,891
Current Liabilities (B)
$33,132
$45,226
Quick Ratio(A/B)
0.45
1.04
With a quick ratio of over 1.0, Johnson & Johnson appears to be in a decent position to cover its current liabilities as its liquid assets are greater than the total of its short-term debt obligations. Procter & Gamble, on the other hand, may not be able to pay off its current obligations using only quick assets as its quick ratio is well below 1, at 0.45. This shows that, disregarding profitability or income, Johnson & Johnson appears to be in better short-term financial health in respects to being able to meet its short-term debt requirements.
Why Is It Called the Quick Ratio?
The quick ratio looks at only the most liquid assets that a company has available to service short-term debts and obligations. Liquid assets are those that can quickly and easily be converted into cash in order to pay those bills.
Why Is the Quick Ratio Important?
The quick ratio communicates how well a company will be able to pay its short-term debts using only the most liquid of assets. The ratio is important because it signals to internal management and external investors whether the company will run out of cash. The quick ratio also holds more value than other liquidity ratios such as the current ratio because it has the most conservative approach on reflecting how a company can raise cash.
Is a Higher Quick Ratio Better?
In general, a higher quick ratio is better. This is because the formula’s numerator (the most liquid current assets) will be higher than the formula’s denominator (the company’s current liabilities). A higher quick ratio signals that a company can be more liquid and generate cash quickly in case of emergency.
Keep in mind that a very high quick ratio may not be better. For example, a company may be sitting on a very large cash balance. This capital could be used to generate company growth or invest in new markets. There is often a fine line between balancing short-term cash needs and spending capital for long-term potential.
How Do the Quick and Current Ratios Differ?
The quick ratio only looks at the most liquid assets on a firm’s balance sheet, and so gives the most immediate picture of liquidity available if needed in a pinch, making it the most conservative measure of liquidity. The current ratio also includes less liquid assets such as inventories and other current assets such as prepaid expenses.
What Happens If the Quick Ratio Indicates a Firm Is Not Liquid?
In this case, a liquidity crisis can arise even at healthy companies—if circumstances arise that make it difficult to meet short-term obligations such as repaying their loans and paying their employees or suppliers. One example of a far-reaching liquidity crisis from recent history is the global credit crunch of 2007-08, where many companies found themselves unable to secure short-term financing to pay their immediate obligations. If new financing cannot be found, the company may be forced to liquidate assets in a fire sale or seek bankruptcy protection.
The Bottom Line
A company can’t exist without cashflow and the ability to pay its bills as they come due. By measuring its quick ratio, a company can better understand what resources they have in the very short-term in case they need to liquidate current assets. Though other liquidity ratios measure a company’s ability to be solvent in the short-term, the quick ratio is among the most aggressive in deciding short-term liquidity capabilities.
A measure of a company’s financial leverage calculated by dividing its long term debt by stockholders’ equity. It indicates what proportion of equity and debt the company is using to finance its assets
What is the Long-Term Debt to Equity Ratio?
The long-term debt to equity ratio is a method used to determine the leverage that a business has taken on. To derive the ratio, divide the long-term debt of an entity by the aggregate amount of its common stock and preferred stock. The formula is:
Long-term debt ÷ (Common stock + Preferred stock) = Long-term debt to equity ratio
When the ratio is comparatively high, it implies that a business is at greater risk of bankruptcy, since it may not be able to pay for the interest expense on the debt if its cash flows decline. This is more of a problem in periods when interest rates are increasing, or when the cash flows of a business are subject to a large amount of variation, or when an entity has relatively minimal cash reserves available to pay down its debt obligations.
The ratio is sometimes used to compare the leverage level of a business with those of its competitors, to see if the leverage level is reasonable.
The standard debt-to-equity ratio can be a more reliable indicator of the financial viability of a business, since it includes all short-term debt as well. This is especially the case when an organization has a large amount of debt coming due within the next year, which would not appear in the long-term debt to equity ratio.
A measure of a company’s financial leverage calculated by dividing its liabilities by stockholders’ equity. It indicates what proportion of equity and debt the company is using to finance its assets
What Is Debt-to-Equity (D/E) Ratio?
Debt-to-equity (D/E) ratio is used to evaluate a company’s financial leverage and is calculated by dividing a company’s total liabilities by its shareholder equity. D/E ratio is an important metric in corporate finance. It is a measure of the degree to which a company is financing its operations with debt rather than its own resources. Debt-to-equity ratio is a particular type of gearing ratio.
KEY TAKEAWAYS
Debt-to-equity (D/E) ratio compares a company’s total liabilities with its shareholder equity and can be used to assess the extent of its reliance on debt.
D/E ratios vary by industry and are best used to compare direct competitors or to measure change in the company’s reliance on debt over time.
Among similar companies, a higher D/E ratio suggests more risk, while a particularly low one may indicate that a business is not taking advantage of debt financing to expand.
Investors will often modify the D/E ratio to consider only long-term debt because it carries more risk than short-term obligations.
The information needed to calculate D/E ratio can be found on a listed company’s balance sheet. Subtracting the value of liabilities on the balance sheet from that of total assets shown there provides the figure for shareholder equity, which is a rearranged version of this balance sheet equation:
These balance sheet categories may include items that would not normally be considered debt or equity in the traditional sense of a loan or an asset. Because the ratio can be distorted by retained earnings or losses, intangible assets, and pension plan adjustments, further research is usually needed to understand to what extent a company relies on debt.
To get a clearer picture and facilitate comparisons, analysts and investors will often modify the D/E ratio. They also assess the D/E ratio in the context of short-term leverage ratios, profitability, and growth expectations.
Business owners use a variety of software to track D/E ratios and other financial metrics. Microsoft Excel provides a balance sheet template that automatically calculates financial ratios such as D/E ratio and debt ratio.1 Or you could enter the values for total liabilities and shareholders’ equity in adjacent spreadsheet cells, say B2 and B3, then add the formula “=B2/B3” in cell B4 to obtain the D/E ratio.
What Does D/E Ratio Tell You?
D/E ratio measures how much debt a company has taken on relative to the value of its assets net of liabilities. Debt must be repaid or refinanced, imposes interest expense that typically can’t be deferred, and could impair or destroy the value of equity in the event of a default. As a result, a high D/E ratio is often associated with high investment risk; it means that a company relies primarily on debt financing.
Debt-financed growth may serve to increase earnings, and if the incremental profit increase exceeds the related rise in debt service costs, then shareholders should expect to benefit. However, if the additional cost of debt financing outweighs the additional income that it generates, then the share price may drop. The cost of debt and a company’s ability to service it can vary with market conditions. As a result, borrowing that seemed prudent at first can prove unprofitable later under different circumstances.
Changes in long-term debt and assets tend to affect D/E ratio the most because the numbers involved tend to be larger than for short-term debt and short-term assets. If investors want to evaluate a company’s short-term leverage and its ability to meet debt obligations that must be paid over a year or less, they can use other ratios.
For example, cash ratio evaluates a company’s near-term liquidity:
Let’s consider a historical example from Apple Inc. (AAPL). We can see below that for the fiscal year (FY) ended 2017, Apple had total liabilities of $241 billion (rounded) and total shareholders’ equity of $134 billion, according to the company’s 10-K statement.2
Using the above formula, the D/E ratio for Apple can be calculated as:
The result means that Apple had $1.80 of debt for every dollar of equity. But on its own, the ratio doesn’t give investors the complete picture. It’s important to compare the ratio with that of other similar companies.
Modifying the D/E Ratio
Not all debt is equally risky. The long-term D/E ratio focuses on riskier long-term debt by using its value instead of that for total liabilities in the numerator of the standard formula:
Long-term D/E ratio = Long-term debt ÷ Shareholder equity
Short-term debt also increases a company’s leverage, of course, but because these liabilities must be paid in a year or less, they aren’t as risky. For example, imagine a company with $1 million in short-term payables (wages, accounts payable, notes, etc.) and $500,000 in long-term debt, compared with a company with $500,000 in short-term payables and $1 million in long-term debt. If both companies have $1.5 million in shareholder equity, then they both have a D/E ratio of 1. On the surface, the risk from leverage is identical, but in reality, the second company is riskier.
As a rule, short-term debt tends to be cheaper than long-term debt and is less sensitive to shifts in interest rates, meaning that the second company’s interest expense and cost of capital are likely higher. If interest rates are higher when the long-term debt comes due and needs to be refinanced, then interest expense will rise.
Finally, if we assume that the company will not default over the next year, then debt due sooner shouldn’t be a concern. In contrast, a company’s ability to service long-term debt will depend on its long-term business prospects, which are less certain.
D/E Ratio for Personal Finances
D/E ratio can apply to personal financial statements as well, serving as a personal D/E ratio. Here, equity refers to the difference between the total value of an individual’s assets and their aggregate debt, or liabilities. The formula for personal D/E ratio is slightly different:
\begin{aligned} &\text{Debt/Equity} = \frac{ \text{Total Personal Liabilities} }{ \text{Personal Assets} – \text{Liabilities} } \\ \end{aligned}Debt/Equity=Personal Assets−LiabilitiesTotal Personal Liabilities
Personal D/E ratio is often used when an individual or a small business is applying for a loan. Lenders use the D/E figure to assess a loan applicant’s ability to continue making loan payments in the event of a temporary loss of income.
For example, a prospective mortgage borrower is more likely to be able to continue making payments during a period of extended unemployment if they have more assets than debt. This is also true for an individual applying for a small business loan or a line of credit. If the business owner has a good personal D/E ratio, it is more likely that they can continue making loan payments until their debt-financed investment starts paying off.
D/E Ratio vs. Gearing Ratio
Gearing ratios constitute a broad category of financial ratios, of which the D/E ratio is the best known. “Gearing” is a term for financial leverage.
Gearing ratios focus more heavily on the concept of leverage than other ratios used in accounting or investment analysis. The underlying principle generally assumes that some leverage is good, but that too much places an organization at risk.
Debt-to-equity ratio is most useful when used to compare direct competitors. If a company’s D/E ratio significantly exceeds those of others in its industry, then its stock could be more risky.
Limitations of D/E Ratio
When using D/E ratio, it is very important to consider the industry in which the company operates. Because different industries have different capital needs and growth rates, a D/E ratio value that’s common in one industry might be a red flag in another.
Utility stocks often have especially high D/E ratios. As a highly regulated industry making large investments typically at a stable rate of return and generating a steady income stream, utilities borrow heavily and relatively cheaply. High leverage ratios in slow-growth industries with stable income represent an efficient use of capital. Companies in the consumer staples sector tend to have high D/E ratios for similar reasons.3
Analysts are not always consistent about what is defined as debt. For example, preferred stock is sometimes considered equity, since preferred dividend payments are not legal obligations and preferred shares rank below all debt (but above common stock) in the priority of their claim on corporate assets. On the other hand, the typically steady preferred dividend, par value, and liquidation rights make preferred shares look more like debt.
Including preferred stock in total debt will increase the D/E ratio and make a company look riskier. Including preferred stock in the equity portion of the D/E ratio will increase the denominator and lower the ratio. This is a particularly thorny issue in analyzing industries notably reliant on preferred stock financing, such as real estate investment trusts (REITs).
What is a good debt-to-equity (D/E) ratio?
What counts as a “good” debt-to-equity (D/E) ratio will depend on the nature of the business and its industry. Generally speaking, a D/E ratio below 1 would be seen as relatively safe, whereas values of 2 or higher might be considered risky. Companies in some industries, such as utilities, consumer staples, and banking, typically have relatively high D/E ratios. Note that a particularly low D/E ratio may be a negative, suggesting that the company is not taking advantage of debt financing and its tax advantages. (Business interest expense is usually tax deductible, while dividend payments are subject to corporate and personal income tax.)
What does a D/E ratio of 1.5 indicate?
A D/E ratio of 1.5 would indicate that the company in question has $1.50 of debt for every $1 of equity. To illustrate, suppose the company had assets of $2 million and liabilities of $1.2 million. Because equity is equal to assets minus liabilities, the company’s equity would be $800,000. Its D/E ratio would therefore be $1.2 million divided by $800,000, or 1.5.
What does a negative D/E ratio signal?
If a company has a negative D/E ratio, this means that it has negative shareholder equity. In other words, the company’s liabilities exceed its assets. In most cases, this would be considered a sign of high risk and an incentive to seek bankruptcy protection.
What industries have high D/E ratios?
In the banking and financial services sector, a relatively high D/E ratio is commonplace. Banks carry higher amounts of debt because they own substantial fixed assets in the form of branch networks. Higher D/E ratios can also tend to predominate in other capital-intensive sectors heavily reliant on debt financing, such as airlines and industrials.
How can D/E ratio be used to measure a company’s riskiness?
A steadily rising D/E ratio may make it harder for a company to obtain financing in the future. The growing reliance on debt could eventually lead to difficulties in servicing the company’s current loan obligations. Very high D/E ratios may eventually result in a loan default or bankruptcy.
The Bottom Line
Debt-to-equity (D/E) ratio can help investors identify highly leveraged companies that may pose risks during business downturns. Investors can compare a company’s D/E ratio with the average for its industry and those of competitors to gain a sense of a company’s reliance on debt. But not all high D/E ratios signal poor business prospects. In fact, debt can enable the company to grow and generate additional income. But if a company has grown increasingly reliant on debt or inordinately so for its industry, potential investors will want to investigate further.
A company’s total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by a company. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations
What Is Gross Profit Margin?
Gross profit margin is a metric analysts use to assess a company’s financial health by calculating the amount of money left over from product sales after subtracting the cost of goods sold (COGS). Sometimes referred to as the gross margin ratio, gross profit margin is frequently expressed as a percentage of sales.
KEY TAKEAWAYS
Gross profit margin is an analytical metric expressed as a company’s net sales minus the cost of goods sold (COGS).
Gross profit margin is often shown as the gross profit as a percentage of net sales.
The gross profit margin shows the amount of profit made before deducting selling, general, and administrative costs, which is the firm’s net profit margin.
A company’s gross profit margin percentage is calculated by first subtracting the cost of goods sold (COGS) from the net sales (gross revenues minus returns, allowances, and discounts). This figure is then divided by net sales, to calculate the gross profit margin in percentage terms.
What Does the Gross Profit Margin Tell You?
If a company’s gross profit margin wildly fluctuates, this may signal poor management practices and/or inferior products. On the other hand, such fluctuations may be justified in cases where a company makes sweeping operational changes to its business model, in which case temporary volatility should be no cause for alarm.
For example, if a company decides to automate certain supply chain functions, the initial investment may be high, but the cost of goods ultimately decreases due to the lower labor costs resulting from the introduction of the automation.
Product pricing adjustments may also influence gross margins. If a company sells its products at a premium, with all other things equal, it has a higher gross margin. But this can be a delicate balancing act because if a company sets its prices overly high, fewer customers may buy the product, and the company may consequently hemorrhage market share.
An Example of Gross Profit Margin Usage
Analysts use gross profit margin to compare a company’s business model with that of its competitors. For example, let us assume that Company ABC and Company XYZ both produce widgets with identical characteristics and similar levels of quality. If Company ABC finds a way to manufacture its product at 1/5 the cost, it will command a higher gross margin because of its reduced costs of goods sold, thereby giving ABC a competitive edge in the market. But then, in an effort to make up for its loss in gross margin, XYZ counters by doubling its product price, as a method of bolstering revenue.
Unfortunately, this strategy may backfire if customers become deterred by the higher price tag, in which case, XYZ loses both gross margin and market share.
Operating margin is a measurement of what proportion of a company’s revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. Calculated as Operating Income / Net Sales.
What Is Operating Margin?
The operating margin measures how much profit a company makes on a dollar of sales after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax. It is calculated by dividing a company’s operating income by its net sales. Higher ratios are generally better, illustrating the company is efficient in its operations and is good at turning sales into profits.
KEY TAKEAWAYS
The operating margin represents how efficiently a company is able to generate profit through its core operations.
It is expressed on a per-sale basis after accounting for variable costs but before paying any interest or taxes (EBIT).
Higher margins are considered better than lower margins, and can be compared between similar competitors but not across different industries.
To calculate the operating margin, divide operating income (earnings) by sales (revenues).
Understanding the Operating Margin
A company’s operating margin, sometimes referred to as return on sales (ROS), is a good indicator of how well it is being managed and how efficient it is at generating profits from sales. It shows the proportion of revenues that are available to cover non-operating costs, such as paying interest, which is why investors and lenders pay close attention to it.
Highly variable operating margins are a prime indicator of business risk. By the same token, looking at a company’s past operating margins is a good way to gauge whether a company’s performance has been getting better. The operating margin can improve through better management controls, more efficient use of resources, improved pricing, and more effective marketing.
In its essence, the operating margin is how much profit a company makes from its core business in relation to its total revenues. This allows investors to see if a company is generating income primarily from its core operations or from other means, such as investing.
When calculating operating margin, the numerator uses a firm’s earnings before interest and taxes (EBIT). EBIT, or operating earnings, is calculated simply as revenue minus cost of goods sold (COGS) and the regular selling, general, and administrative costs of running a business, excluding interest and taxes.
Example
For example, if a company had revenues of $2 million, COGS of $700,000, and administrative expenses of $500,000, its operating earnings would be $2 million – ($700,000 + $500,000) = $800,000. Its operating margin would then be $800,000 / $2 million = 40%.
If the company was able to negotiate better prices with its suppliers, reducing its COGS to $500,000, then it would see an improvement in its operating margin to 50%.
Limitations of the Operating Margin
The operating margin should only be used to compare companies that operate in the same industry and, ideally, have similar business models and annual sales. Companies in different industries with wildly different business models have very different operating margins, so comparing them would be meaningless. It would not be an apples-to-apples comparison.
To make it easier to compare profitability between companies and industries, many analysts use a profitability ratio that eliminates the effects of financing, accounting, and tax policies: earnings before interest, taxes, depreciation, and amortization (EBITDA). For example, by adding back depreciation, the operating margins of big manufacturing firms and heavy industrial companies are more comparable.
EBITDA is sometimes used as a proxy for operating cash flow because it excludes non-cash expenses, such as depreciation. However, EBITDA does not equal cash flow. This is because it does not adjust for any increase in working capital or account for capital expenditure that is needed to support production and maintain a company’s asset base—as operating cash flow does.
Other Profit Margins
By comparing EBIT to sales, operating profit margins show how successful a company’s management has been at generating income from the operation of the business. There are several other margin calculations that businesses and analysts can employ to get slightly different insights into a firm’s profitability.
The gross margin tells us how much profit a company makes on its cost of sales, or COGS. In other words, it indicates how efficiently management uses labor and supplies in the production process.
The net margin considers the net profits generated from all segments of a business, accounting for all costs and accounting items incurred, including taxes and depreciation. In other words, this ratio compares net income with sales. It comes as close as possible to summing up in a single figure how effectively the managers are running a business.
Why Is Operating Margin Important?
The operating margin is an important measure of a company’s overall profitability from operations. It is the ratio of operating profits to revenues for a company or business segment.
Expressed as a percentage, the operating margin shows how much earnings from operations is generated from every $1 in sales after accounting for the direct costs involved in earning those revenues. Larger margins mean that more of every dollar in sales is kept as profit.
How Can Companies Improve Their Net Profit Margin?
When a company’s operating margin exceeds the average for its industry, it is said to have a competitive advantage, meaning it is more successful than other companies that have similar operations. While the average margin for different industries varies widely, businesses can gain a competitive advantage in general by increasing sales or reducing expenses—or both.
Boosting sales, however, often involves spending more money to do so, which equals greater costs. Cutting too many costs can also lead to undesirable outcomes, including losing skilled workers, shifting to inferior materials, or other losses in quality. Cutting advertising budgets may also harm sales.
To reduce the cost of production without sacrificing quality, the best option for many businesses is expansion. Economies of scale refer to the idea that larger companies tend to be more profitable. A large business’s increased level of production means that the cost of each item is reduced in several ways. For example, raw materials purchased in bulk are often discounted by wholesalers.
How Is Operating Margin Different From Other Profit Margin Measures?
Operating margin takes into account all operating costs but excludes any non-operating costs. Net profit margin takes into account all costs involved in a sale, making it the most comprehensive and conservative measure of profitability. Gross margin, on the other hand, simply looks at the costs of goods sold (COGS) and ignores things such as overhead, fixed costs, interest expenses, and taxes.
What Are Some High and Low Profit Margin Industries?
High operating margin sectors typically include those in the services industry, as there are fewer assets involved in the production than an assembly line. Similarly, software or gaming companies may invest initially while developing a particular software/game and cash in big later by simply selling millions of copies with very little expense. Meanwhile, luxury goods and high-end accessories often operate on high-profit potential and low sales.
Operations-intensive businesses such as transportation, which may have to deal with fluctuating fuel prices, drivers’ perks and retention, and vehicle maintenance, usually have lower operating margins. Agriculture-based ventures, too, usually have lower margins owing to weather uncertainty, high inventory, operational overheads, need for farming and storage space, and resource-intensive activities.
Automobiles also have low margins, as profits and sales are limited by intense competition, uncertain consumer demand, and high operational expenses involved in developing dealership networks and logistics.
A ratio of profitability calculated as net income divided by revenues, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings.
What Is Profit Margin?
Profit margin is one of the commonly used profitability ratios to gauge the degree to which a company or a business activity makes money. It represents what percentage of sales has turned into profits. Simply put, the percentage figure indicates how many cents of profit the business has generated for each dollar of sale. For instance, if a business reports that it achieved a 35% profit margin during the last quarter, it means that it had a net income of $0.35 for each dollar of sales generated.
There are several types of profit margin. In everyday use, however, it usually refers to net profit margin, a company’s bottom line after all other expenses, including taxes and one-off oddities, have been taken out of revenue.
KEY TAKEAWAYS
Profit margin gauges the degree to which a company or a business activity makes money, essentially by dividing income by revenues.
Expressed as a percentage, profit margin indicates how many cents of profit has been generated for each dollar of sale.
While there are several types of profit margin, the most significant and commonly used is net profit margin, a company’s bottom line after all other expenses, including taxes and one-off oddities, have been removed from revenue.
Profit margins are used by creditors, investors, and businesses themselves as indicators of a company’s financial health, management’s skill, and growth potential.
As typical profit margins vary by industry sector, care should be taken when comparing the figures for different businesses.
Understanding Profit Margin
Businesses and individuals across the globe perform for-profit economic activities with the aim to generate profits. However, absolute numbers—like $X million worth of gross sales, $Y thousand business expenses, or $Z earnings—fail to provide a clear and realistic picture of a business’s profitability and performance. Several different quantitative measures are used to compute the gains (or losses) a business generates, which makes it easier to assess the performance of a business over different time periods or compare it against competitors. These measures are called profit margins.
While proprietary businesses, like local shops, may compute profit margins at their own desired frequency (like weekly or fortnightly), large businesses including listed companies are required to report it in accordance with the standard reporting timeframes (like quarterly or annually). Businesses that may be running on loaned money may be required to compute and report it to the lender (like a bank) on a monthly basis as a part of standard procedures.
There are four levels of profit or profit margins:
Gross profit
Operating profit
Pre-tax profit
Net profit
These are reflected on a company’s income statement in the following sequence: A company takes in sales revenue, then pays direct costs of the product or service. What’s left is the gross margin. Then it pays indirect costs like company headquarters, advertising, and R&D. What’s left is the operating margin. Then it pays interest on debt and adds or subtracts any unusual charges or inflows unrelated to the company’s main business with a pre-tax margin left over. Then it pays taxes, leaving the net margin, also known as net income, which is the very bottom line.
There are other key profitability ratios that analysts and investors commonly use to determine the financial health and well-being of a company. The return on assets (ROA) analyzes how well a company deploys its assets to generate a profit after factoring in expenses. A company’s return on equity (ROE) determines a company’s return based on its equity investments.
Types of Profit Margin
Let’s look more closely at the different varieties of profit margins.
Gross Profit Margin
Gross profit margin: Start with sales and take out costs directly related to creating or providing the product or service like raw materials, labor, and so on—typically bundled as “cost of goods sold,” “cost of products sold,” or “cost of sales” on the income statement—and you get gross margin. Done on a per-product basis, gross margin is most useful for a company analyzing its product suite (though this data isn’t shared with the public), but aggregate gross margin does show a company’s rawest profitability picture. As a formula:
Operating Profit Margin or just operating margin: By subtracting selling, general and administrative, or operating expenses, from a company’s gross profit number, we get operating profit margin, also known as earnings before interest and taxes, or EBIT.
This results in an income figure that’s available to pay the business’ debt and equity holders, as well as the tax department, its profit from a company’s main, ongoing operations. it’s frequently used by bankers and analysts to value an entire company for potential buyouts. As a formula:
Pretax profit margin: Take operating income and subtract interest expense while adding any interest income, adjust for non-recurring items like gains or losses from discontinued operations, and you’ve got pre-tax profit, or earnings before taxes (EBT). Divide this figure by revenue, and you’ve got the pretax profit margin.
The major profit margins all compare some level of residual (leftover) profit to sales. For instance, a 42% gross margin means that for every $100 in revenue, the company pays $58 in costs directly connected to producing the product or service, leaving $42 as gross profit.
Net Profit Margin
Let’s now consider net profit margin, the most significant of all the measures—and what people usually mean when they ask, “what’s the company’s profit margin?”
Net profit margin is calculated by dividing the net profits by net sales, or by dividing the net income by revenue realized over a given time period. In the context of profit margin calculations, net profit and net income are used interchangeably. Similarly, sales and revenue are used interchangeably. Net profit is determined by subtracting all the associated expenses, including costs towards raw material, labor, operations, rentals, interest payments, and taxes, from the total revenue generated.
Mathematically, Profit Margin = Net Profits (or Income) / Net Sales (or Revenue)
=(Net Sales – Expenses) / Net Sales
=1- (Expenses / Net Sales)
\begin{aligned} &\begin{gathered} \textit{NPM }=\left(\frac{\textit{R }-\textit{ COGS }-\textit{ OE }-\textit{ O }-\textit{ I }-\textit{ T}}{\textit{R}}\right)\ \times100\\ \textbf{or}\\ \textit{NPM }=\ \left(\frac{\textit{Net income}}{\textit{R}}\right)\times100 \end{gathered}\\ &\textbf{where:}\\ &NPM=\text{net profit margin}\\ &R=\text{revenue}\\ &COGS=\text{cost of goods sold}\\ &OE=\text{operating expenses}\\ &O=\text{other expenses}\\ &I=\text{interest}\\ &T=\text{taxes} \end{aligned}NPM =(RR − COGS − OE − O − I − T)×100orNPM =(RNet income)×100where:NPM=net profit marginR=revenueCOGS=cost of goods soldOE=operating expensesO=other expensesI=interestT=taxes
Dividends paid out are not considered an expense, and are not considered in the formula.
Taking a simple example, if a business realized net sales worth $100,000 in the previous quarter and spent a total of $80,000 towards various expenses, then
Profit Margin = 1 – ($80,000 / $100,000)
= 1- 0.8
= 0.2 or 20%
It indicates that over the quarter, the business managed to generate profits worth 20 cents for every dollar worth of sales. Let’s consider this example as the base case for future comparisons that follow.
Analyzing the Profit Margin Formula
A closer look at the formula indicates that profit margin is derived from two numbers—sales and expenses. To maximize the profit margin, which is calculated as {1 – (Expenses/ Net Sales)}, one would look to minimize the result achieved from the division of (Expenses/Net Sales). That can be achieved when Expenses are low and Net Sales are high.
Let’s understand it by expanding the above base case example.
If the same business generates the same amount of sales worth $100,000 by spending only $50,000, its profit margin would come to {1 – $50,000/$100,000)} = 50%. If the costs for generating the same sales further reduces to $25,000, the profit margin shoots up to {1 – $25,000/$100,000)} = 75%. In summary, reducing costs helps improve the profit margin.
On the other hand, if the expenses are kept fixed at $80,000 and sales improve to $160,000, profit margin rises to {1 – $80,000/$160,000)} = 50%. Raising the revenue further to $200,000 with the same expense amount leads to profit margin of {1 – $80,000/$200,000)} = 60%. In summary, increasing sales also bumps up the profit margins.
Based on the above scenarios, it can be generalized that the profit margin can be improved by increasing sales and reducing costs. Theoretically, higher sales can be achieved by either increasing the prices or increasing the volume of units sold, or both.
Practically, a price rise is possible only to the extent of not losing the competitive edge in the marketplace, while sales volumes remain dependent on market dynamics like overall demand, percentage of market share commanded by the business, and competitors’ existing position and future moves. Similarly, the scope for cost controls is also limited. One may reduce/eliminate a non-profitable product line to curtail expenses, but the business will also lose out on the corresponding sales.
In all scenarios, it becomes a fine balancing act for the business operators to adjust pricing, volume, and cost controls. Essentially, profit margin acts as an indicator of business owners’ or management’s adeptness in implementing pricing strategies that lead to higher sales and efficiently controlling the various costs to keep them minimal.
Using Profit Margin
From a billion-dollar publicly listed company to an average Joe’s sidewalk hot dog stand, the profit margin figure is widely used and quoted by all kinds of businesses across the globe. It is also used to indicate the profitability potential of larger sectors and of overall national or regional markets. It is common to see headlines like “ABC Research warns on declining profit margins of American auto sector,” or “European corporate profit margins are breaking out.”
In essence, the profit margin has become the globally adopted standard measure of the profit-generating capacity of a business and is a top-level indicator of its potential. It is one of the first few key figures to be quoted in the quarterly results reports that companies issue.
Business owners, company management, and external consultants use it internally for addressing operational issues and to study seasonal patterns and corporate performance during different timeframes. A zero or negative profit margin translates to a business either struggling to manage its expenses or failing to achieve good sales. Drilling it down further helps identify the leaking areas—like high unsold inventory, excess yet underutilized employees and resources, or high rentals—and then devise appropriate action plans.
Enterprises operating multiple business divisions, product lines, stores, or geographically spread-out facilities may use profit margin for assessing the performance of each unit and compare it against one another.
Profit margins often come into play when a company seeks funding. Individual businesses, like a local retail store, may need to provide it for seeking (or restructuring) a loan from banks and other lenders. It also becomes important while taking out a loan against a business as collateral.
Large corporations issuing debt to raise money are required to reveal their intended use of collected capital, and that provides insights to investors about profit margin that can be achieved either by cost cutting, increasing sales, or a combination of both. The number has become an integral part of equity valuations in the primary market for initial public offerings (IPOs).
Finally, profit margins are a significant consideration for investors. Investors looking at funding a particular startup may like to assess the profit margin of the potential product/service being developed. While comparing two or more ventures or stocks to identify the better one, investors often hone in on the respective profit margins.
Comparing Profit Margins
Profit margin cannot be the sole decider for comparison as each business has its own distinct operations. Businesses with low-profit margins, like retail and transportation, will usually have high turnaround and revenue which makes up for overall high profits despite the relatively low-profit margin figure. High-end luxury goods have low sales, but high profits per unit make up for high-profit margins.
Below is a comparison between the profit margins of four long-running and successful companies in the technology and retail space:
Technology companies like Microsoft and Alphabet have high double-digit quarterly profit margins compared to the single-digit margins achieved by Walmart and Target. However, it does not mean Walmart and Target did not generate profits or were less successful businesses compared to Microsoft and Alphabet.
A look at stock returns between 2006 and 2012 indicate similar performances across the four stocks, though Microsoft and Alphabet’s profit margin were way ahead of Walmart and Target’s during that period. Since they belong to different sectors, a blind comparison solely on profit margins may be inappropriate. Profit margin comparisons between Microsoft and Alphabet, and between Walmart and Target is more appropriate.
Examples of High Profit Margin Industries
Businesses of luxury goods and high-end accessories often operate on high profit potential and low sales. Few costly items, like a high-end car, are ordered to build—that is, the unit is manufactured after securing the order from the customer, making it a low-expense process without much operational overheads.
Software or gaming companies may invest initially while developing a particular software/game and cash in big later by simply selling millions of copies with very little expenses. Getting into strategic agreements with device manufacturers, like offering pre-installed Windows and MS Office on Dell-manufactured laptops, further reduces the costs while maintaining revenues.
Patent-secured businesses like pharmaceuticals may incur high research costs initially, but they reap big with high profit margins while selling the patent-protected drugs with no competition.
Examples of Low Profit Margin Industries
Operation-intensive businesses like transportation which may have to deal with fluctuating fuel prices, drivers’ perks and retention, and vehicle maintenance usually have lower profit margins.
Agriculture-based ventures usually have low profit margins owing to weather uncertainty, high inventory, operational overheads, need for farming and storage space, and resource-intensive activities.
Automobiles also have low profit margins, as profits and sales are limited by intense competition, uncertain consumer demand, and high operational expenses involved in developing dealership networks and logistics.
How Do You Define Profit Margin?
A profit margin is a profitability ratio that can tell you whether a company makes money. It highlights what portion of the company’s sales have turned into profits or how many cents per dollar it generates per sale. Profit margins allow analysts and investors to determine the financial health and well-being of certain companies. Types of profit margins include gross profit margins and operating profit margins.
How Do You Calculate Profit Margins?
You can easily determine a company’s profit margin by subtracting the cost of goods sold (COGS) from its total revenue and dividing that figure by the total revenue. Multiply that figure by 100 to get a percentage. So a company with revenue of $1,000 and COGS of $200 has a profit margin of 80% or ($1,000 – $200) ÷ $1,000.
What’s the Difference Between Gross Profit Margin and Operating Profit Margin?
Gross profit margin refers to a company’s net sales less the total cost of goods sold. This metric shows how much of a profit a company makes before any deductions are made, including general and administrative costs. Operating profit margin, on the other hand, refers to any profit that a company makes after it pays for certain variable costs, such as wages and raw materials.
The Bottom Line
There are many different metrics that analysts and investors can use to help them determine whether a company is financially healthy and sound. One of these is the profit margin. It does this by taking the sales that a company converts into a profit and turning it into a percentage. In simpler terms, a company’s profit margin is the total number of cents per dollar earned on a sale that the company keeps as a profit.
These margins can be divided into different categories, such as gross and operating profit margins. But the most common is the net profit margin, which is what we normally call a company’s bottom line. This figure is what’s left after any taxes and any other expenses have been deducted.
A measure of a stock’s price volatility relative to the market. An asset with a beta of 0 means that its price is not at all correlated with the market. A positive beta means that the asset generally follows the market. A negative beta shows that the asset inversely follows the market, decreases in value if the market goes up
What Is Beta?
Beta (β) is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole (usually the S&P 500). Stocks with betas higher than 1.0 can be interpreted as more volatile than the S&P 500.
Beta is used in the capital asset pricing model (CAPM), which describes the relationship between systematic risk and expected return for assets (usually stocks). CAPM is widely used as a method for pricing risky securities and for generating estimates of the expected returns of assets, considering both the risk of those assets and the cost of capital.
KEY TAKEAWAYS
Beta (β), primarily used in the capital asset pricing model (CAPM), is a measure of the volatility–or systematic risk–of a security or portfolio compared to the market as a whole.
Beta data about an individual stock can only provide an investor with an approximation of how much risk the stock will add to a (presumably) diversified portfolio.
For beta to be meaningful, the stock should be related to the benchmark that is used in the calculation.
The S&P 500 has a beta of 1.0.
Stocks with betas above 1 will tend to move with more momentum than the S&P 500; stocks with betas less than 1 with less momentum.
How Beta Works
A beta coefficient can measure the volatility of an individual stock compared to the systematic risk of the entire market. In statistical terms, beta represents the slope of the line through a regression of data points. In finance, each of these data points represents an individual stock’s returns against those of the market as a whole.
Beta effectively describes the activity of a security’s returns as it responds to swings in the market. A security’s beta is calculated by dividing the product of the covariance of the security’s returns and the market’s returns by the variance of the market’s returns over a specified period.
The Calculation for Beta Is As Follows:
\begin{aligned} &\text{Beta coefficient}(\beta) = \frac{\text{Covariance}(R_e, R_m)}{\text{Variance}(R_m)} \\ &\textbf{where:}\\ &R_e=\text{the return on an individual stock}\\ &R_m=\text{the return on the overall market}\\ &\text{Covariance}=\text{how changes in a stock’s returns are} \\ &\text{related to changes in the market’s returns}\\ &\text{Variance}=\text{how far the market’s data points spread} \\ &\text{out from their average value} \\ \end{aligned}Beta coefficient(β)=Variance(Rm)Covariance(Re,Rm)where:Re=the return on an individual stockRm=the return on the overall marketCovariance=how changes in a stock’s returns arerelated to changes in the market’s returnsVariance=how far the market’s data points spreadout from their average value
The beta calculation is used to help investors understand whether a stock moves in the same direction as the rest of the market. It also provides insights into how volatile–or how risky–a stock is relative to the rest of the market. For beta to provide any useful insight, the market that is used as a benchmark should be related to the stock. For example, calculating a bond ETF’s beta using the S&P 500 as the benchmark would not provide much helpful insight for an investor because bonds and stocks are too dissimilar.
Understanding Beta
Ultimately, an investor is using beta to try to gauge how much risk a stock is adding to a portfolio. While a stock that deviates very little from the market doesn’t add a lot of risk to a portfolio, it also doesn’t increase the potential for greater returns.
In order to make sure that a specific stock is being compared to the right benchmark, it should have a high R-squared value in relation to the benchmark. R-squared is a statistical measure that shows the percentage of a security’s historical price movements that can be explained by movements in the benchmark index. When using beta to determine the degree of systematic risk, a security with a high R-squared value, in relation to its benchmark, could indicate a more relevant benchmark.
For example, a gold exchange-traded fund (ETF), such as the SPDR Gold Shares (GLD), is tied to the performance of gold bullion.1 Consequently, a gold ETF would have a low beta and R-squared relationship with the S&P 500.
One way for a stock investor to think about risk is to split it into two categories. The first category is called systematic risk, which is the risk of the entire market declining. The financial crisis in 2008 is an example of a systematic-risk event; no amount of diversification could have prevented investors from losing value in their stock portfolios. Systematic risk is also known as un-diversifiable risk.
Unsystematic risk, also known as diversifiable risk, is the uncertainty associated with an individual stock or industry. For example, the surprise announcement that the company Lumber Liquidators (LL) had been selling hardwood flooring with dangerous levels of formaldehyde in 2015 is an example of unsystematic risk.2 It was risk that was specific to that company. Unsystematic risk can be partially mitigated through diversification.
A stock’s beta will change over time as it relates a stock’s performance to the returns of the overall market, which is a dynamic process.
Types of Beta Values
Beta Value Equal to 1.0
If a stock has a beta of 1.0, it indicates that its price activity is strongly correlated with the market. A stock with a beta of 1.0 has systematic risk. However, the beta calculation can’t detect any unsystematic risk. Adding a stock to a portfolio with a beta of 1.0 doesn’t add any risk to the portfolio, but it also doesn’t increase the likelihood that the portfolio will provide an excess return.
Beta Value Less Than One
A beta value that is less than 1.0 means that the security is theoretically less volatile than the market. Including this stock in a portfolio makes it less risky than the same portfolio without the stock. For example, utility stocks often have low betas because they tend to move more slowly than market averages.
Beta Value Greater Than One
A beta that is greater than 1.0 indicates that the security’s price is theoretically more volatile than the market. For example, if a stock’s beta is 1.2, it is assumed to be 20% more volatile than the market. Technology stocks and small cap stocks tend to have higher betas than the market benchmark. This indicates that adding the stock to a portfolio will increase the portfolio’s risk, but may also increase its expected return.
Negative Beta Value
Some stocks have negative betas. A beta of -1.0 means that the stock is inversely correlated to the market benchmark on a 1:1 basis. This stock could be thought of as an opposite, mirror image of the benchmark’s trends. Put options and inverse ETFs are designed to have negative betas. There are also a few industry groups, like gold miners, where a negative beta is also common.
Beta in Theory vs. Beta in Practice
The beta coefficient theory assumes that stock returns are normally distributed from a statistical perspective. However, financial markets are prone to large surprises. In reality, returns aren’t always normally distributed. Therefore, what a stock’s beta might predict about a stock’s future movement isn’t always true.
A stock with a very low beta could have smaller price swings, yet it could still be in a long-term downtrend. So, adding a down-trending stock with a low beta decreases risk in a portfolio only if the investor defines risk strictly in terms of volatility (rather than as the potential for losses). From a practical perspective, a low beta stock that’s experiencing a downtrend isn’t likely to improve a portfolio’s performance.
Similarly, a high beta stock that is volatile in a mostly upward direction will increase the risk of a portfolio, but it may add gains as well. It’s recommended that investors using beta to evaluate a stock also evaluate it from other perspectives—such as fundamental or technical factors—before assuming it will add or remove risk from a portfolio.
Drawbacks of Beta
While beta can offer some useful information when evaluating a stock, it does have some limitations. Beta is useful in determining a security’s short-term risk, and for analyzing volatility to arrive at equity costs when using the CAPM. However, since beta is calculated using historical data points, it becomes less meaningful for investors looking to predict a stock’s future movements. Beta is also less useful for long-term investments since a stock’s volatility can change significantly from year to year, depending upon the company’s growth stage and other factors. Furthermore, the beta measure on a particular stock tends to jump around over time, which makes it unreliable as a stable measure.
What Is a Good Beta for a Stock?
Beta is used as a proxy for a stock’s riskiness or volatility relative to the broader market. A good beta will, therefore, rely on your risk tolerance and goals. If you wish to replicate the broader market in your portfolio, for instance via an index ETF, a beta of 1.0 would be ideal. If you are a conservative investor looking to preserve principal, a lower beta may be more appropriate. In a bull market, betas greater than 1.0 will tend to produce above-average returns – but will also produce larger losses in a down market.
Is Beta a Good Measure of Risk?
Many experts agree that while Beta provides some information about risk, it is not an effective measure of risk on its own. Beta only looks at a stock’s past performance relative to the S&P 500 and does not provide any forward guidance. It also does not consider the fundamentals of a company or its earnings and growth potential.
How Do You Interpret a Stock’s Beta?
A Beta of 1.0 for a stock means that it has been just as volatile as the broader market (i.e., the S&P 500 index). If the index moves up or down 1%, so too would the stock, on average. Betas larger than 1.0 indicate greater volatility – so if the beta were 1.5 and the index moved up or down 1%, the stock would have moved 1.5%, on average. Betas less than 1.0 indicate less volatility: if the stock had a beta of 0.5, it would have risen or fallen just half-a-percent as the index moved 1%.
A statistical measure of the dispersion of returns for a given stock. Represents average daily high/low % range.
What Is Volatility?
Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security. Volatility is often measured from either the standard deviation or variance between returns from that same security or market index.
In the securities markets, volatility is often associated with big swings in either direction. For example, when the stock market rises and falls more than one percent over a sustained period of time, it is called a “volatile” market. An asset’s volatility is a key factor when pricing options contracts.
KEY TAKEAWAYS
Volatility represents how large an asset’s prices swing around the mean price—it is a statistical measure of its dispersion of returns.
There are several ways to measure volatility, including beta coefficients, option pricing models, and standard deviations of returns.
Volatile assets are often considered riskier than less volatile assets because the price is expected to be less predictable.
Volatility is an important variable for calculating options prices.
Understanding Volatility
Volatility often refers to the amount of uncertainty or risk related to the size of changes in a security’s value. A higher volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically, and tends to be more steady.
One way to measure an asset’s variation is to quantify the daily returns (percent move on a daily basis) of the asset. Historical volatility is based on historical prices and represents the degree of variability in the returns of an asset. This number is without a unit and is expressed as a percentage.
While variance captures the dispersion of returns around the mean of an asset in general, volatility is a measure of that variance bounded by a specific period of time. Thus, we can report daily volatility, weekly, monthly, or annualized volatility. It is, therefore, useful to think of volatility as the annualized standard deviation.
How to Calculate Volatility
Volatility is often calculated using variance and standard deviation (the standard deviation is the square root of the variance). Since volatility describes changes over a specific period of time you simply take the standard deviation and multiply that by the square root of the number of periods in question:
vol = σ√T
where:
v = volatility over some interval of time
σ =standard deviation of returns
T = number of periods in the time horizon
For simplicity, let’s assume we have monthly stock closing prices of $1 through $10. For example, month one is $1, month two is $2, and so on. To calculate variance, follow the five steps below.
Find the mean of the data set. This means adding each value and then dividing it by the number of values. If we add, $1, plus $2, plus $3, all the way to up to $10, we get $55. This is divided by 10 because we have 10 numbers in our data set. This provides a mean, or average price, of $5.50.
Calculate the difference between each data value and the mean. This is often called deviation. For example, we take $10 – $5.50 = $4.50, then $9 – $5.50 = $3.50. This continues all the way down to the first data value of $1. Negative numbers are allowed. Since we need each value, these calculations are frequently done in a spreadsheet.
Square the deviations. This will eliminate negative values.
Add the squared deviations together. In our example, this equals 82.5.
Divide the sum of the squared deviations (82.5) by the number of data values.
In this case, the resulting variance is $8.25. The square root is taken to get the standard deviation. This equals $2.87. This is a measure of risk and shows how values are spread out around the average price. It gives traders an idea of how far the price may deviate from the average.
Investopedia / Sabrina Jiang
If prices are randomly sampled from a normal distribution, then about 68% of all data values will fall within one standard deviation. Ninety-five percent of data values will fall within two standard deviations (2 x 2.87 in our example), and 99.7% of all values will fall within three standard deviations (3 x 2.87). In this case, the values of $1 to $10 are not randomly distributed on a bell curve; rather. they are uniformly distributed. Therefore, the expected 68%–95%º–99.7% percentages do not hold. Despite this limitation, traders frequently use standard deviation, as price returns data sets often resemble more of a normal (bell curve) distribution than in the given example.
The volatility of stock prices is thought to be mean-reverting, meaning that periods of high volatility often moderate and periods of low volatility pick up, fluctuating around some long-term mean.
Types of Volatility
Implied Volatility
Implied volatility (IV), also known as projected volatility, is one of the most important metrics for options traders. As the name suggests, it allows them to make a determination of just how volatile the market will be going forward. This concept also gives traders a way to calculate probability. One important point to note is that it shouldn’t be considered science, so it doesn’t provide a forecast of how the market will move in the future.
Unlike historical volatility, implied volatility comes from the price of an option itself and represents volatility expectations for the future. Because it is implied, traders cannot use past performance as an indicator of future performance. Instead, they have to estimate the potential of the option in the market.
Implied volatility is a key feature of options trading.
Historical Volatility
Also referred to as statistical volatility, historical volatility (HV) gauges the fluctuations of underlying securities by measuring price changes over predetermined periods of time. It is the less prevalent metric compared to implied volatility because it isn’t forward-looking.
When there is a rise in historical volatility, a security’s price will also move more than normal. At this time, there is an expectation that something will or has changed. If the historical volatility is dropping, on the other hand, it means any uncertainty has been eliminated, so things return to the way they were.
This calculation may be based on intraday changes, but often measures movements based on the change from one closing price to the next. Depending on the intended duration of the options trade, historical volatility can be measured in increments ranging anywhere from 10 to 180 trading days.
Volatility and Options Pricing
Volatility is a key variable in options pricing models, estimating the extent to which the return of the underlying asset will fluctuate between now and the option’s expiration. Volatility, as expressed as a percentage coefficient within option-pricing formulas, arises from daily trading activities. How volatility is measured will affect the value of the coefficient used.
Volatility is also used to price options contracts using models like Black-Scholes or binomial tree models. More volatile underlying assets will translate to higher options premiums because with volatility there is a greater probability that the options will end up in-the-money at expiration. Options traders try to predict an asset’s future volatility, so the price of an option in the market reflects its implied volatility.
The greater the volatility, the higher the market price of options contracts across the board.
Other Measures of Volatility
Beta
One measure of the relative volatility of a particular stock to the market is its beta (β). A beta approximates the overall volatility of a security’s returns against the returns of a relevant benchmark (usually the S&P 500 is used). For example, a stock with a beta value of 1.1 has historically moved 110% for every 100% move in the benchmark, based on price level.
Conversely, a stock with a beta of .9 has historically moved 90% for every 100% move in the underlying index.
The VIX
Market volatility can also be seen through the VIX or Volatility Index, a numeric measure of broad market volatility. The VIX was created by the Chicago Board Options Exchange as a measure to gauge the 30-day expected volatility of the U.S. stock market derived from real-time quote prices of S&P 500 call and put options.1 It is effectively a gauge of future bets investors and traders are making on the direction of the markets or individual securities. A high reading on the VIX implies a risky market.
Traders can also trade the VIX using a variety of options and exchange-traded products, or they can use VIX values to price certain derivatives products.
Example of Volatility
Suppose that an investor is building a retirement portfolio. Since she is retiring within the next few years, she’s seeking stocks with low volatility and steady returns. She considers two companies:
ABC Corp. has a beta coefficient of .78, which makes it slightly less volatile than the S&P 500 index.2
XYZ, Inc. has a beta coefficient of 1.45, making it significantly more volatile than the S&P 500 index.3
A more conservative investor may choose ACorporation for their portfolio, since it has less volatility and more predictable short-term value
Tips on Managing Volatility
Investors can find periods of high volatility to be distressing as prices can swing wildly or fall suddenly. Long-term investors are best advised to ignore periods of short-term volatility and stay the course. This is because over the long run, stock markets tend to rise. Meanwhile, emotions like fear and greed, which can become amplified in volatility markets, can undermine your long-term strategy. Some investors can also use volatility as an opportunity to add to their portfolios by buying the dips, when prices are relatively cheap.
You can also use hedging strategies to navigate volatility, such as buying protective puts to limit downside losses without having to sell any shares. But note that put options will also become more pricey when volatility is higher.
What Is Volatility, Mathematically?
Volatility is a statistical measure of the dispersion of data around its mean over a certain period of time. It’s calculated as the standard deviation multiplied by the square root of the number of periods of time, T. In finance, it represents this dispersion of market prices, on an annualized basis.
Is Volatility the Same As Risk?
Volatility is often used to describe risk, but this is necessarily always the case. Risk involves the chances of experiencing a loss, while volatility describes how large and quickly prices move. If those increased price movements also increase the chance of losses, then risk is likewise increased.
Is Volatility a Good Thing?
Whether volatility is a good or bad thing depends on what kind of trader you are and what your risk appetite is. For long-term investors, volatility can spell trouble, but for day traders and options traders, volatility often equals trading opportunities.
What Does a High Volatility Mean?
If volatility is high, it means that prices are moving (both up and down) quickly and steeply.
What Is the VIX?
The VIX is the CBOE volatility index, a measure of the short-term volatility in the broader market, measured by the implied volatility of 30-day S&P 500 options contracts. The VIX generally rises when stocks fall, and declines when stocks rise. Also known as the “fear index,” the VIX can thus be a gauge of market sentiment, with higher values indicating greater volatility and greater fear among investors.
The Bottom Line
Volatility is how much and how quickly prices move over a given span of time. In the stock market, increased volatility is often a sign of fear and uncertainty among investors. This is why the VIX volatility index is sometimes called the “fear index.” At the same time, volatility can create opportunities for day traders to enter and exit positions. Volatility is also a key component in options pricing and trading.
Ratio between current volume and 3-month average value, intraday adjusted.
What is Relative Volume?
Relative Volume (often times called RVOL) is an indicator that tells traders how current trading volume is compared to past trading volume over a given period.
It is kind of a like a radar for how “in-play” a stock is.
The higher the relative volume is the more in play it is because more traders are watching and trading it.
As traders, this is what we want.
Stocks that have a lot of volume have more liquidity and tend to trade better than stocks with low relative volume.
The RVOL is displayed as a ratio.
So if it is showing 3.5 relative volume, that means it is trading at 3.5 times its normal volume for that time period.
As day traders we like to see RVOL at 2 or higher with a positive catalyst, low float and ideally a higher short interest.
When all this falls in line together we have a recipe for parabolic moves that can make trading months and sometimes even years.
This is also a good metric to watch for potential bottoming or topping in stocks.
As a stock gets oversold or overbought we want to look for volume to get a spike in relative volume which would indicate that buyers and seller are fighting over an important support or resistance level and will likely reverse.
Warrior Trading Pro Tip
RVOL is often overlooked, especially by new traders, but it is important to understand this metric and to add it into your morning preparation.
Knowing what other traders are watching and trading is key to understanding what stocks are in play and which ones will likely make big moves.
GLBS Relative Volume
A good example is in the 15-min chart above of GLBS. They were in play the last couple of days as you can see by the increased volume compared to previous days.
This is what we like to see in a stock to confirm that a lot of traders are watching it and that it is “in play”. Trading stocks out of play means there will be less traders watching it and will likely result in false breakouts or choppy price action with less predictable moves.
Also, with higher relative volume you will have more liquidity in the stock which will tighten spreads and allow you to trade with more size without a ton of slippage.
Relative Volume Trading Strategy
Relative volume is a great indicator to keep a close eye on, but like most indicators it works best in conjunction with other indicators and on different time frames.
For example, I like to see how the RVOL is compared to previous trading days but I also like to check it versus opening drives and second leg drives to compare strength.
NVDA Relative Volume
In the 1-minute chart of NVDA you will see that it had a very strong opening drive. After a strong move like that I like to see it have a pull back to support or the VWAP on lighter volume before making another leg up.
In this case, it came back to support at $97.75 where it consolidated in a tight wedge pattern before breaking out to the upside. The key to this strategy is on the breakout that is marked by the green arrow.
This is where you would look to get long but only if volume confirms the move. You can see at the bottom of the chart that volume spiked when it broke out of the pattern and held above the resistance line.
This is a great indication that buyers want to take prices higher with a great risk/reward entry.
What is Relative Volume?
Relative Volume (often times called RVOL) is an indicator that tells traders how current trading volume is compared to past trading volume over a given period.
It is kind of a like a radar for how “in-play” a stock is.
The higher the relative volume is the more in play it is because more traders are watching and trading it.
As traders, this is what we want.
Stocks that have a lot of volume have more liquidity and tend to trade better than stocks with low relative volume.
The RVOL is displayed as a ratio.
So if it is showing 3.5 relative volume, that means it is trading at 3.5 times its normal volume for that time period.
As day traders we like to see RVOL at 2 or higher with a positive catalyst, low float and ideally a higher short interest.
When all this falls in line together we have a recipe for parabolic moves that can make trading months and sometimes even years.
This is also a good metric to watch for potential bottoming or topping in stocks.
As a stock gets oversold or overbought we want to look for volume to get a spike in relative volume which would indicate that buyers and seller are fighting over an important support or resistance level and will likely reverse.
Warrior Trading Pro Tip
RVOL is often overlooked, especially by new traders, but it is important to understand this metric and to add it into your morning preparation.
Knowing what other traders are watching and trading is key to understanding what stocks are in play and which ones will likely make big moves.
GLBS Relative Volume
A good example is in the 15-min chart above of GLBS. They were in play the last couple of days as you can see by the increased volume compared to previous days.
This is what we like to see in a stock to confirm that a lot of traders are watching it and that it is “in play”. Trading stocks out of play means there will be less traders watching it and will likely result in false breakouts or choppy price action with less predictable moves.
Also, with higher relative volume you will have more liquidity in the stock which will tighten spreads and allow you to trade with more size without a ton of slippage.
Relative Volume Trading Strategy
Relative volume is a great indicator to keep a close eye on, but like most indicators it works best in conjunction with other indicators and on different time frames.
For example, I like to see how the RVOL is compared to previous trading days but I also like to check it versus opening drives and second leg drives to compare strength.
NVDA Relative Volume
In the 1-minute chart of NVDA you will see that it had a very strong opening drive. After a strong move like that I like to see it have a pull back to support or the VWAP on lighter volume before making another leg up.
In this case, it came back to support at $97.75 where it consolidated in a tight wedge pattern before breaking out to the upside. The key to this strategy is on the breakout that is marked by the green arrow.
This is where you would look to get long but only if volume confirms the move. You can see at the bottom of the chart that volume spiked when it broke out of the pattern and held above the resistance line.
This is a great indication that buyers want to take prices higher with a great risk/reward entry.
The company’s nearest earnings-report date. The earnings reports of significant companies should also be watched carefully as they may have great influence on the stock market overall.
A price target is an analyst’s projection of a security’s future price. Price targets can pertain to all types of securities, from complex investment products to stocks and bonds. When setting a stock’s price target, an analyst is trying to determine what the stock is worth and where the price will be in 12 or 18 months. Ultimately, price targets depend on the valuation of the company that’s issuing the stock.
Analysts generally publish their price targets in research reports on specific companies, along with their buy, sell, and hold recommendations for the company’s stock. Stock price targets are often quoted in the financial news media.
KEY TAKEAWAYS
A price target is an analyst’s projection of a security’s future price, one at which an analyst believes a stock is fairly valued.
Analysts consider numerous fundamental and technical factors to arrive at a price target.
Analysts generally publish their price targets along with their buy, sell, and hold recommendations for a stock.
Price targets for the same security can be different because of the various valuation methods used by analysts, traders, and institutions.
Price Target
Understanding Price Targets
A price target is a price at which an analyst believes a stock to be fairly valued relative to its projected and historical earnings. When an analyst raises their price target for a stock, they generally expect the stock price to rise.
Conversely, lowering their price target may mean that the analyst expects the stock price to fall. Price targets are an organic factor in financial analysis; they can change over time as new information becomes available.
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