Thursday, April 29, 2010

Other ways to assess financial health

Beyond profitability, operating, and leverage ratios, other ways of evaluating the financial health of a company include valuation, Economic Value Added (EVA), and assessing growth and productivity. Like the ratios described above, all of these measures are most meaningful when compared against the same measures for other companies in that particular industry.

Valuation. Wall Street investors and stock analysts scrutinize a company's financial statements and stock performance carefully in order to arrive at what they believe to be a realistic estimate of that company's value. Since a share of stock denotes ownership of a part of the company, analysts are interested in knowing whether the market price of that share is a good deal relative to the underlying value of the piece of the company the share represents.

Wall Street uses various means of valuation, that is, of assessing a company's financial performance in relation to its stock price.

The earnings per share (EPS) equals net income divided by the number of shares outstanding. This is one of the most commonly watched indicators of a company's financial performance. If it falls, it will likely take the stock's price down with it.

The price-to-earnings ratio (PE) is the current price of a share of stock divided by the previous 12 months' earnings per share. It is a common measure of how cheap or expensive a stock is, relative to earnings.

The price-to-book ratio is the current market price of a share of stock divided by a stock's book value per share. (To calculate the book value, subtract the preferred stock total from total equities, then divide the result by the number of shares outstanding.)

Growth indicators. Growth measures can tell a great deal about financial health. A company's growth allows it to provide increasing returns to its shareholders, and to provide opportunities for new and existing employees. The number of years over which you should measure growth will depend on the business cycle of the industry the company is in. A one-year growth figure for an oil company—an industry that typically has long business cycles—probably doesn't tell you very much. But a strong one-year growth figure for an Internet company would be significant. Common measures of growth include sales growth, profitability growth, and growth in earnings per share.

Economic Value Added (EVA). This concept was introduced as a way to induce employees to think like shareholders and owners. It is the profit left over after the company has met the cost of capital—the expectations of those who provided the capital. (Another way to describe cost of capital is that it is the weighted cost average to the company of acquiring debt and equity financing.)

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