Lesson Objective: To calculate and interpret key financial ratios and apply financial statement analysis to estimate the intrinsic value of a company using models such as the dividend discount model (DDM) and the price/earnings (P/E) model.

In-Depth Notes:

1. The Importance of Ratio Analysis:
Financial ratios are used to assess a company’s performance, financial health, and valuation relative to its peers and industry benchmarks. Ratio analysis is a fundamental tool for investment analysis, helping to identify trends, strengths, and weaknesses in a company’s financial position.

2. Categories of Financial Ratios:

• Profitability Ratios:

  • Gross Profit Margin: Gross Profit / Revenue

  • Operating Margin: Operating Income / Revenue

  • Net Profit Margin: Net Income / Revenue

  • Return on Equity (ROE): Net Income / Shareholders' Equity

  • Return on Assets (ROA): Net Income / Total Assets

• Liquidity Ratios:

  • Current Ratio: Current Assets / Current Liabilities

  • Quick Ratio: (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities

• Solvency and Leverage Ratios:

  • Debt-to-Equity Ratio: Total Debt / Shareholders' Equity

  • Debt-to-Assets Ratio: Total Debt / Total Assets

  • Interest Coverage Ratio: EBIT / Interest Expense

• Activity and Efficiency Ratios:

  • Inventory Turnover: COGS / Average Inventory

  • Days Sales Outstanding (DSO): (Average Accounts Receivable / Revenue) × 365

  • Days Payable Outstanding (DPO): (Average Accounts Payable / COGS) × 365

  • Asset Turnover: Revenue / Total Assets

• Valuation Ratios:

  • Price-to-Earnings (P/E) Ratio: Market Price per Share / Earnings per Share

  • Price-to-Book (P/B) Ratio: Market Price per Share / Book Value per Share

  • Price-to-Sales (P/S) Ratio: Market Capitalization / Revenue

  • Enterprise Value-to-EBITDA (EV/EBITDA): Enterprise Value / EBITDA

3. The DuPont Analysis:
The DuPont analysis is a framework for decomposing ROE into its components:
ROE = Net Profit Margin × Asset Turnover × Financial Leverage

• Net Profit Margin: Measures operating efficiency.

• Asset Turnover: Measures asset use efficiency.

• Financial Leverage: Measures the use of debt financing.

4. Valuation Models Based on Financial Statements:

• The Dividend Discount Model (DDM): Values a stock based on the present value of its expected future dividends.

  • Value per Share = Σ [Dividend per Share t / (1 + Cost of Equity)^t]

  • Gordon Growth Model: A simplified version of the DDM that assumes dividends grow at a constant rate (g):

    • Value per Share = Dividend per Share (next year) / (Cost of Equity - g)

• The Price/Earnings (P/E) Model: Values a stock using the P/E ratio.

  • Value per Share = EPS × Target P/E Ratio

  • Justified P/E: The P/E ratio that is consistent with the company’s fundamentals (growth rate, payout ratio, required return).

    • Justified P/E = (Payout Ratio) / (Required Return - Growth Rate)

5. Using Ratio Analysis in Investment Decisions:

• Peer Comparison: Comparing a company’s ratios to those of its competitors and industry averages.

• Historical Trend Analysis: Analyzing a company’s ratios over time to identify trends.

• Screen for Investment Candidates: Using ratios to screen for companies that meet specific investment criteria.

• Valuation: Applying valuation models to estimate a company’s intrinsic value and identify mispriced securities