A contingent liability is, as the name suggests, contingent
or dependent upon a future event and if that event happens or does
not happen. For example, if a company thinks it will face a potential
lawsuit in the future, this is a contingent liability because it
could win the case, or lose it, if it happens. Another example is
if your parents guarantee the mortgage on your home, then if you
make all your payments on time and do not default on your mortgage,
there is no contingent liability on your parents. If you fail to
make the payments, your parents will incur a liability. Another
example is when a company is sued for $50,000 by a former employee
for harassment or discrimination; the company will have a contingent
liability. If the company wins the case, they will not have a liability
but if they lose, they will incur a liability.
Economic
Value Added is a performance ratio that determines the true economic
profitability of a corporation because it factors in net operating
income after taxes & interest minus the opportunity cost of
capital deployed to earn that net operating income. In other words,
Economic Value Added shows whether the financial performance of
a company exceeds or is below the minimum required rate of return
for shareholders or business lenders. Economic Value Added tells
investors whether the amount of capital they have invested in to
the business is generating them higher return than their minimum,
or if it is better to invest the capital elsewhere. Here is how
Economic Value Added (EVA) is used by financial analysts:
i) Economic Value Added is used as a performance
evaluation tool of higher level managers, directors, VPs
and CEOs of a corporation because the performance of the organization
depends on the human resources deployed.
ii) Economic Value Added is used at sub-division
level & entire organizational level of the business,
unlike other methods such as Market Value Added that only focuses
on the big picture of a corporation.
iii) Economic Value Added factors in to performance
evaluation that the operating net income of a corporation must cover
both operating costs of the organization as well as the
capital costs (opportunity cost of capital). This is unlike other
accounting methods such as EBIT or EBITDA or Net Income that look
at total revenues generated by the business minus total expenses
as a performance evaluation tool.
How to Calculate Economic Value Added
Net Sales
-
Operating Expenses
___________________________
Operating Profit (EBIT)
- Taxes
___________________________
Net Operating Profit After Tax (NOPAT)
- Capital Costs (Total Capital x Cost of Capital)
___________________________
EBITDA
stands for Earnings before Interest, Taxes, Depreciation & Amortization
expense. EBITDA is a tool to measure the value of a firm
based on its net earnings before non-cash expenses (depreciation
& amortization) are recorded, as well as dilutive expenses such
as interest expense & taxes. EBIDTA is used by financial valuation
experts to measure the true value of a business, especially for
private capital firms. Here is why private capital banks like the
EBITDA formula:
i) Interest & Taxes - Replace
current tax rates & Interest rates with their own tax &
interest rates based on the current & new capital structure
of the corporation, new debt convenants or refinancing with the
banks.
ii) Amortization & Depreciation - These
are excluded because they are non-cash expenses for capital or intangible
assets which were acquired in prior periods, and do not represent
a cash outlay of the organization.
Financial advisors recommend using EBITDA as a way
to measure the cash generation activities of an organization. The
formula for Earnings before Interest, Taxes, Depreciation &
Amortization is:
EBITDA
= Net Sales - Operating Expenses = Operating Profit
Return
on Invesment as the name suggests is a financial valuation method
that determines the percent of return investors are getting from
their portfolio of investments. Return on Investment is probably
one of the most important ratios that companies need to keep track
of in order to determine the viability & continuity of their
business.Measuring profit margins of products being sold is not
enough to continue doing business, companies have to ensure the
amount of capital that is being put in to the business is attracting
sufficient sales & providing a good return on capital invested.
As a rule of thumb, if the ROI is too low, this means
the product lines are not generating enough sales worth running
the business and deploying overhead costs, thus in the long term
the product line is deemed to fail. The formula for Return on Investment
is:
ROI
= Net Income / Book Value of Assets
An alternative formula for ROI is:
ROI
= Net Income + Interest (1 - Tax Rate) / Book Value of Assets
Another formula that small investors use to calculate
ROI is:
ROI
= (Gain from Investment - Cost of Investment) / Cost of Investment
For instance, assume you are the VP of a long distance
phone company that does a marketing campaign to generate new buyers
of its long distance phone cards. The company sells each phone card
for $5, and does an advertising campaign on the radio/television
worth $500,000. This campaign helps the company sell an additional
155,500 long distance phone cards off its distribution networks.
What is the ROI? (View Full)
Return
on Invested Capital (ROIC) is a top level way to measure
the historical & current performance of a corporation across
all the capital it has invested in its business. This capital comes
from shareholders (investors), creditors who supply loans, credit
as well as shares owned by management. One of the best ways to measure
how a company has performed in the past on its allocated capital
resources is by the Return on Invested Capital ratio. Other similar
formulas such as the Discounted Cash Flow (DCF) measures the performance
of a company based on its present & future cash flows, but they
are easy to manipulate. For instance, a company could easily decrease
its outgoing cash flows by:
- Postponing marketing expenses
- Delaying research & development costs
- Cutting back on capital spending
- Laying off workforce
A solid Return on Invested Capital ratio indicates
strong management, efficient business operations & use of capital
resources as well as value creation opportunities for the organization.
The ROIC formula should be used with care as it can mean negative
things for the organization such as not exploring growth opportunities
for the organization, ignoring long term net positive value investments,
stingy cash preservation, excessive convervatism, etc. To create
growth in the future, companies must earn an ROIC above their Cost
of Capital (WACC). The accounting formula for this relationship
is:
Future
Growth = Return on Invested Capital - Weighted Average Cost
of Capital
There are 2 formulas we could use to calculate ROIC.
(View Full)
The
Operating Cash Flow (Cash Flows from Operations) measures how further
away Cash Flow is from the company's reported Net Income or Operating
Income. Under the Generally Accepted Accounting Principles (GAAP),
companies can report good Net Income numbers even though their cash
flows are poor due to entries such as Accrued Revenues, etc. In
simpler terms, Operating Cash Flow is a verification of quality
of the company's reported earnings. Some financial experts argue
Operating Cash Flow is a better tool of evaluating earnings than
Operating or Net Income because a company can show positive net
income but still not have enough cash to meet its debt covenants
& obligations such as bonds payable, rent expense, salaries
expense, etc. There are 2 formulas for calculating the Operating
Cash Flow:
1) Cash Flow from Operations =
Income
from Continuing Operations + Non-Cash Expenses - Non-Cash
Sales
Income
from Operations
2) Cash Flow from Operations =
Net
Income + Non-Cash Expenses - Non-Cash Sales
Net
Income
Differences between Operating Cash Flows and
Reported Earnings indicates large amounts of non-cash expenses such
as amortization expense, goodwill impairments, etc. If a company
reports high earnings but with negative operating cash flows, this
presents a red flag that it may be using aggressive accounting techniques
that could mislead investors & public using the financial statements
of the company.
Operating Cash Flow is sometimes referred to
as Free Cash Flow because this cash is 'Free' to be paid back to
the suppliers of capital (shareholders and creditors).
Financial
analysts use Earnings per Share as a way to determine the relative
corporate value of a stock. The dividends declared on preferred
stock are subtracted from Net income, and this number is then divided
by Weighted Average number of Outstanding Common shares & its
equivalents. Earnings per Share is very commonly used by the media
to evaluate the value of a stock, e.g. if you go to Google Finance,
you will see EPS in the summary of a stock along with other measurements
such as Price to Earnings ratio,
dividend yield, low & high range of a stock, 52 week trading
high, etc.
The two most commonly used formulas for calculating
Earnings per share include:
i) Earnings Per Share
(Net
Income - Preferred Stock Dividends) /
Weighted
Average # of Common Shares & Equivalents
or
ii) Fully Diluted EPS
(Net
Income - Preferred Stock Dividends)
/
#
of Outstanding Common Shares & Common Share Equivalents
The 2nd formula where the denominator is # of Common
Shares Outstanding & Common Share Equivalents is known as the
Fully Diluted EPS. It is 'fully diluted' because all convertible
bonds, preferred stock, convertible warrants and stock warrants
& rights are included in the calculation.
How EPS is Calculated
Earnings per share is a way of standardizing a company's
net income left over for shareholders across all companies. For
instance, two Companies A & B could earn $10 million a year,
but
Company A has 50,000 shares outstanding while Company
B has 500,000 shares outstanding. So how would you normalize earnings
per share across these two companies?
Company
A = $10 million / 50,000 shares = $200 / share
Company
B = $10 million / 500,000 shares = $20 / share
The
Price to Earnings ratio compares the current price of a common stock
trading on the market with the Earnings per Share (EPS) that the
company yields. Earnings per Share is calculated by dividing
Net Income in current quarter by the total # of shares outstanding
on the market. The price to earnings ratio is a widely used stock
valuation tool as it indicates to investors how 'cheap' or 'expensive'
a stock is and you will see analysts on Bloomberg television referring
to the P/E ratio in part of their analysis & discussions about
stocks. For example, assume Farhan Corp. currently has its A Class
common stock trading at $45 per share and total # of shares on the
market is 50,000. Net income as at February 28th, 2010 is $2million.
What is the Earnings per Share?
Earnings
per Share = Net Income / Total # of Shares Outstanding
Earnings
per Share = $2,000,000 / 450,000 shares
Earnings
per Share = 4.44 cents a share
Having this data, what will be the Price to
Earnings ratio?
P/E
ratio = Current Price / EPS
P/E ratio
= $45 / 4.44
P/E
ratio = 10.135
Earnings per share data of a stock is commonly found
in Google Finance or from the annual reports of your prospective
company. Another way to derive Earnings per Share is to estimate
based on the EPS of last 4 quarters.
Disadvantages of using EPS
1) The price to earnings ratio is based on future estimates
of earnings or net income such as the prevailing estimate of EPS
of the last 4 quarters. With the high volatility in the
stock markets and lots of businesses going bankruptcy, future estimates
of accounting earnings or net income should be taken not very seriously
as they are just estimates and could be way off from actual performance.
If the dividend grows at a steady rate, we do not
need to forecast an infinite number of future dividends; however
we just need to come up with a single growth rate which is a lot
simpler. Taking D0 to be the dividend just paid and g to be the
constant growth rate, the value of one share of stock can be simply
written as:
We have therefore just derived the dividend growth
model which is a model that determines the current price or value
of a share of stock as its dividend next period divided by the discount
rate minus the dividend growth rate.
Bank of America Dividend Growth Model Application
- Example
Bank
of America announces its next dividend will be $2 a share and from
research we know that investors typically require a 14% annual rate
of return from American banks, thus this will be the required rate
of return. The bank increases its dividend at a steady rate of 8%
a year. Based on the dividend growth model, what is the value of
the Bank of America stock today? What is the value in 4 years?
a) Since we are already given the next dividend as
$2 per share, we will not multiply D1 with (1 + g) as it is given
as $2. Having said this, the dividend growth formula we will use
is:
P0
= D1 / (r – g)
P0 = 2 / (0.14 – 0.08)
P0 = 2 / 0.06
P0 = $33.33
b) Since we already know the dividend in one year,
the dividend in four years is equal to:
Shares
of common stock are more difficult to value than say a bond payable
because of three inherent reasons:
i) The promised cash flows from common
stocks are not known in advance as opposed to bond payable
where we know the cash flows.
ii) The life of common stocks is forever
because they have no maturity as opposed to bonds payable
that have a maturity date.
iii) There is no set way of coming up
with a required rate of return as stocks fluctuate in value
quite a bit.
Deriving the Common Stock Valuation Formula
Having said this, how can we value common stocks and
discount them for the present values? Imagine that you buy a share
of common stock today and plan to sell the stock in one year. From
insider knowledge, you know that the stock will be worth $80 in
one year. You also think that the stock will pay $8 per share dividend
at the end of the year. If you require a 15% return on your investment,
what is the most you would pay for this stock as of now? In other
words, what is the present value of the $8 dividend along with the
$80 ending value of the stock at 15% required rate of return? Here’s
how to calculate this:
Present Value = ($8 + $80) / 1.15
Present Value = $76.52
Therefore, the perceived present value of this investment
will be $76.52 today. This formula can be put in more explicit terms
as follows:
P0 = (D1 + P1) /
(1 + r)
Where:
P0
= Current price of the stock
P1 = Price of the stock in 1 year (or one
period)
D1 = Dividend expected to be paid at the
end of the period (year)
R = required rate of return on this investment
in the market today
Applied
predetermined overhead rate is a cost accounting method that applies
estimated labour or machine cost per hour to total # of actual hours
in a given period, to derive the total cost of production, whether
it is machine use or physical labour hours. This method is commonly
used to apply factory overhead to a given job or product. The formula
for applied predetermined overhead rate is:
* Budgeted annual activity hours include direct labour
& machine hours.
Example
Assume a factory calculates its predetermined overhead
rate based on machine use or hours. Budgeted overhead is estimated
at $600,000 while budgeted machine hours are estimated at 150,000.
The applied overhead rate is calculated as:
Arbitrage
refers to the ability of investors to trade in complementary securities
(buying and selling stocks, commodities or ETFs) in two different
markets at the same time. The purpose of using arbitrage is to take
advantage of market inefficiencies where one stock might be trading
for $500 on the NYSE while it could be trading at $450 on the London
stock exchange. Investors who engage in arbitrage are known as Arbitragers.
Arbitrage basically takes advantage of the price differences between
two comparable commodities or securities trading simultaneously
on two different secondary markets or stock exchanges. An arbitrage
investor (arbitrager) buys a security on the exchange with the lower
price and sells it right away on the exchange that offers a higher
price, for a profit or capital gain. The formula for arbitrage is:
P
= (Yb– Xa) x Q
Where:
P = Arbitrage profit
Yb = price of
higher priced security on the higher trading exchange –
We’ll call it the exchange B.
Xa = Price of
lower priced security on the lower trading exchange –
We’ll call it the exchange A.
Q = Quantity
Example 1
Say for instance Binti Kiziwi Corp (ticker symbol
BKC) is trading for $80 per share on the New York stock exchange
(NYSE) while it is trading for $95 per share on the Toronto stock
exchange (TSX). An arbitrage investor buys 2000 shares of the stock
on the New York stock exchange for $80/share and sells it simultaneously
on the Toronto stock exchange for $95/share, thus making a decent
profit of $15/share.
The arbitrage profit will therefore be:
P
= (Yb– Xa) x Q
P = ($95 – $80) x
2000 shares
P = $15 x 2000 shares
P = $30,000
The arbitrage profit is $30,000. This transaction
and similar transactions to this one will increase the value of
the stock on the New York stock exchange as arbitragers will be
buying and driving up demand in an attempt to lock in profit. However,
the price of the security on the Toronto stock exchange will go
lower because arbitragers will be dumping the stocks in that exchange
in order to make their profits; for instance even if the arbitrager
sells the shares at $93/share on the TSX instead of the $95 current
trading price, he will still make a very good gain on his sale;
this will therefore drive prices of that security on the TSX downwards.