Depreciation can be explained well according to accounting language as a method used or allowing companies and organizations to write off or decrease a documented cost of an asset systematically over a given time. It is normally used to account for the reduction in value, which is the difference in initial cost and the accrued cost of an asset over time (Liapis et al., 2015)
Depreciation can be computed by deducting an asset's salvage value from its cost to determine the amount that can be depreciated. The resulting amount is then divided by the number of years of those particular assets’ beneficial lifespan. When the goal is to calculate the monthly depreciation, the obtained amount can then be divided by 12 to get the monthly depreciation amount.
The major and common types of depreciation methods that are highly effective in determining the book value of assets and used in numerous organizations include the following:
In accounting, the straight-line depreciation method is used to calculate the depreciation of assets and is viewed by many as the simplest method of all to determine the loss value of an asset over a given time. This can be computed by dividing the difference between an asset's cost and its projected salvage cost, by the number of years it is anticipated to be used. In calculating the straight-line method, the salvage value is subtracted from the purchase value, and the resulting amount is then divided by the number of years that the particular asset is likely or anticipated to be useful.
Straight-line depreciation = (Asset's purchase price – the salvage value)/ Projected useful life of the asset
Many financial organizations prefer this method of depreciation since it has few errors when carrying out computations and is also easier to use. It uses fewer variables during the computations, so it is user-friendly and self-explanatory. However, this method has a drawback concerning obsolescence. This can be shown in the notion that technological advancement could render an asset outdated earlier than expected. The loss of an asset's value in the short term is not factored in by this method, but instead the long run, and the fact that an asset can be more expensive to maintain as it gets worn out (Ibarra, 2013)
This is a faster and enhanced depreciation method whereby expenses decrease with the age of the fixed asset. The depreciation rate is applied to the book value of the asset at the start of the financial period when determining depreciation expenditures within the decreasing balances. In a real sense, assets are more productive in their new state, and productivity decreases slowly as a result of wear and tear, and technology being rendered obsolete. Therefore, when they are still new, assets have a higher profit. For correct and valid statements, matching principles require us to pair expenses with revenues, which is achieved pretty well with the aid of the declining balance depreciation method.
Declining balance depreciation = A ×1/(Useful life) ×(C-AD)
Whereby, A equals to accelerator, C equals to cost and AD equals to accumulated depreciation.
It can be noted that no depreciation can be charged at any given time when the asset's book value equals that of the salvage value (Beaver et al.,1974)
This is a form of accelerated depreciation since the depreciation expense is quicker in the initial years of the asset's life but slower in the later years. Double here implies 200% of the straight-line depreciation rate. On the other hand, a declining balance depicts assets carrying value at the initial stages of the accounting period.
To calculate this type of depreciation, 100% is divided by the number of years in an asset's beneficial life, thus obtaining a straight-line depreciation rate. The resulting number is then multiplied by two to obtain the double-declining depreciation rate. While using this method, it should be noted that depreciation of an asset continues until its value declines to its salvage value.
Straight-line depreciation = (Asset's purchase price – the salvage value)/ Projected useful life of the asset
Double declining depreciation rate = straight-line depreciation × 2 (Schwab et al., 2020)
This is a method applied when calculating asset depreciation over time. It's a critical method that is necessary when the assets are closely related to the total number of units that a particular asset produces instead of linking an asset with the number of years it is actually in use.
This is an instrumental method of calculation, which usually results in greater deductions being taken for depreciation in years when assets are in constant use. This can, later on, cover for the periods when the asset was not being used efficiently. The formula for the unit of production depreciation rate can be represented as illustrated below. Firstly, the depreciation expense for a given year is obtained, and then multiplied by the units per year.
Depreciation expense = (Original value-salvage value)/(Estimated production capability) × Units per year
This method is based on the principle of an asset's production capability or rather percentage capacity that was initially used during a given financial period. It is useful for companies or organizations in taking greater deductions of depreciation at a particular period when a given asset was very productive. Besides, this method can help an organization to keep track of all profits and losses very accurately (Liapis et al., 2015)
This is a form of accelerated depreciation linked to an assumption that the output or yield of an asset diminishes as time passes. By dividing the remaining beneficial life of an asset by the number of years, a fraction is determined which is then applied to the depreciable amount, i.e. cost of the asset, to come up with the depreciation expense for a particular time.
This method charges higher expenses of depreciation in initial years when the asset is still beneficial and productive before it is rendered obsolete. The most appropriate formula that can be used to compute this type of depreciation is:
Depreciation expense = (Remaining useful time of an asset)/(Sum of years digits) × Depreciable cost
It can be noted that using this method, the reported profit of a venture is decreased over the near term. This can result in low profits in the near term but above average profits later on within a given financial period. It can also have a severe impact on cash flow since the amount of taxable income is reduced, thus the payment of income tax is extended to take place in the later periods (Noland, 2011)
Compound interest is the interest on a deposit or loan that is calculated not only on the initial principal but also on the accrued interest from prior periods. Compound interest is also known as interest on interest because the borrower has to pay interest on principal as well on previous interest. Of course, it provides a greater return on investment than simple interest, which is calculated exclusively on the initial principal.
Learning how to calculate compound interest is not difficult when you understand the compound interest formula, that is:
FV = PA*(1+i/n)nt
Let's break down the individual components of the compound interest formula:
To illustrate, we can conduct a compound interest example calculation. Let’s assume Alex invests $100,000 in a high-yield saving account with an interest rate of 3%, compounded quarterly. Alex could use the compounded interest formula to calculate the investment's future value after twenty (20) years:
FV = $100,000*(1+0.03/4)20*4
The future value of Alex's investment after twenty (20) years would be $181,804. To determine the exact amount earned with compound interest, we should subtract the deposit's principal from the calculation. Here's the formula for calculating compound interest earnings alone:
CI = PA*(1+i/n)nt - PA
It is worth noting that the higher the compounding frequency, the higher the investment’s return. That happens because compound interest is calculated both on the principal amount and on the accrued interest from prior periods. To illustrate, let's calculate Alex's investment’s future value with an interest rate compounded quarterly instead of annually.
FV = $100,000*(1+0.03)20
The future value of Alex's investment after twenty (20) years with a 3% interest rate compounded annually would be $180,611, which is $1,193 lower than the same amount invested at the same interest rate but with a quarterly compounding frequency.
Simple interest received or paid over an investment time horizon is a fixed payment calculated as a percentage of the borrowed or lent initial principal. On the other hand, compound interest is the interest on a deposit or loan that is calculated not only on the initial principal but also on the accrued interest from prior periods, giving the investor a greater return on their investment than simple interest.
To illustrate, let's calculate Alex's investment’s future value with a simple interest rate and compare the results with the same amount invested with a compound interest rate. Below is the formula to calculate the future value of an investment with a simple interest rate:
FV = PA*(1+i*t)
So, Alex's investment future value with a simple interest rate would be:
FV = $100,000*(1+0.03*20)
The future value of Alex's investment after twenty (20) years with a 3% simple interest rate would be $160,000, which is $21,804 lower than the same amount invested at the same interest rate but with a quarterly compounding frequency.
]]>The CEO, that stands for Chief Executive Officer, is the most important executive in a corporation who has the final say on the company's most critical decisions. The CEO is also known as managing director, president, or chief executive.
The Chief Executive Officer is responsible for the organization's performance and reports directly to and is accountable to the Board of Directors (BoD), a governing body elected to represent the company's shareholders.
The CEO has different roles and responsibilities based on the company's size and organizational structure. While in large corporations they only deal with the company's most critical decisions, in smaller businesses, the CEO may also make lower-level decisions (such as recruiting staff). In large corporations, these tasks are usually delegated to department directors.
In any case, the first and most important responsibility of a CEO is to develop and execute the most appropriate long-term strategies to increase shareholders' value. Other roles and responsibilities of a CEO include:
A company's CEO and the Chairperson of the Board are both elected by the Board of Directors but have different roles and responsibilities. As discussed above, the CEO is the most important executive in a corporation who has the final say on the company's most critical decisions.
The Chairperson of the Board, on the other hand, is elected to protect shareholders' interest. The Board of Directors regularly meets during the year to review financial results and evaluate executives' and managers' performance. Furthermore, the CEO needs the approval of the Board for any critical business decision.
It can happen that the same person is both the CEO and the Chairperson of the Board. Still, most companies require a separation of roles to avoid conflict of interest. In many countries, the CEO and the Chairperson of the Board can't be the same person because it is prohibited by law. It's easy to understand why, let's imagine a Chairperson of the Board voting on increasing the CEO’s compensation when they are the same person.
Ticker |
Company |
CEO |
Year |
CEO Pay |
Sundar Pichai |
2019 |
$280,621,552 |
||
Robert Swan |
2019 |
$66,935,100 |
||
Lisa Su |
2019 |
$58,534,288 |
||
John Plant |
2019 |
$51,712,578 |
||
Robert Iger |
2019 |
$47,517,762 |
||
David Zaslav |
2019 |
$45,843,912 |
||
Miguel Patricio |
2019 |
$43,297,480 |
||
Satya Nadella |
2019 |
$42,910,215 |
||
Lachlan Murdoch |
2019 |
$42,111,103 |
||
William McDermott |
2019 |
$41,682,335 |
Source: AFLCIO
]]>By definition, Shareholders’ Equity, or Stockholders’ Equity, is the net worth of a company's shareholders after all debt has been repaid. The amount is disclosed on a firm's balance sheet and is equal to the sum of contributed capital plus retained earnings.
As discussed in our balance sheet guide, the statement of financial position is known as a balance sheet because it is maintained to ensure that a company's assets are always equal to the sum of liabilities and shareholders’ equity. Thus, investors can get to shareholders’ equity by applying the balance sheet equation, that is:
Shareholders’ Equity = Assets - Liabilities
Now that you know what stockholders’ equity is, let's take a look at Apple's 2019 balance sheet to get a real example of shareholders' equity. As depicted below, it consists of common stock and additional paid-in capital (share capital), and retained earnings. You can also observe that both total assets and liabilities plus stockholders' equity are equal to 338,516 million.
Source: Apple's 10K, Oct 31, 2019
As anticipated above, the main components of shareholders' equity are contributed capital and retained earnings. Share capital consists of the amount of money invested by stockholders. For example, if an entrepreneur starts a company investing $1 million, cash (asset) grows by $1 million, and share capital (on the shareholders' equity) goes up by the same amount.
Businesses can increase their share capital by issuing additional common stocks or preferred stocks. However, if a company issues new shares of stock, it reduces existing shareholders' proportional ownership. This mechanism is known as share dilution, a problem that every company looking for funding must pay attention to.
As depicted in Apple's balance sheet above, the shareholders' equity section on the balance sheet can include some other share-related terms, such as:
As you can guess, the number of treasury shares is equal to the difference between shares issued and shares outstanding. The following graph summarizes the relationship between the different types of shares.
The retained earnings account on the shareholders' equity section of the balance sheet consists of a company’s earnings that are not distributed as dividends to shareholders but are retained to invest and self-fund the company's growth.
Firms calculate retained earnings using the following formula:
Retained Earnings = Beginning Period Retained Earnings + Net Income/Loss – Dividends Paid
To illustrate, we can use the shareholders' equity formula to calculate Microsoft's (MSFT) stockholders' equity. Using the Finbox data explorer, we can find the values of the metrics required to apply the formula:
We can now calculate Microsoft's shareholders' equity by subtracting total liabilities from total assets:
MSFT's Shareholders’ Equity = MSFT's Total Assets - MSFT's Total Liabilities
MSFT's Shareholders’ Equity = $301B - $177.69B = $123.31
Stockholders’ equity can be positive or negative. A positive shareholders’ equity indicates that the business can cover its liabilities with its own assets. In other words, the company's assets are greater than the company's liabilities.
On the other hand, a negative shareholders’ equity is a warning sign that indicates that the firm's total liabilities exceed total assets. This is an unsustainable capital structure that can lead to the company's bankruptcy in the long term.
]]>If you are interested in learning how to value a company using different valuation methods, you are in the right place. Evaluating the intrinsic value of stocks is not an easy task, and one of the main difficulties for many analysts is choosing the correct valuation method.
It's very important to master multiple valuation models to find the intrinsic value of a business. Being biased towards one particular methodology could negatively impact investment decisions and result in capital losses and missed opportunities! This article will discuss the most popular valuation methods to find a company's fair value.
Discounted Cash Flow (DCF) valuation is one of the most popular methods used by equity analysts to estimate a company's fair value based on forecasts of how much cash flow it will generate in the future.
So, the first step to build a DCF valuation model is forecasting future free cash flows. Since FCF can be challenging to estimate directly, it is common practice to forecast revenue first and arrive at FCF by making the required adjustments.
Since we can't forecast cash flows perpetually, most analysts project them for five or ten years and then estimate a Terminal Value, which represents the value of the business at the end of the forecast period.
Once we've forecasted the company's future free cash flows and its terminal value, we have to find their present value by discounting them back to the present using our required rate of return. The resulting value is the amount an investor needs to pay for the business to achieve their desired rate of return.
Any price lower than the DCF value will result in a higher rate of return. On the flip side, if the investor pays more than the DCF value, he should expect to get a lower rate of return. Below is an example of Apple's DCF analysis results. According to the model, Apple's fair value is equal to $84.51, representing a -29% downside from the current price of $119.03.
Source: Finbox DCF Analysis Summary (You can access the full model for free here)
Comparable Companies Analysis, otherwise known as “comps,” is a widely used valuation method that estimates a business’s fair value by comparing its valuation metrics with its peers, which are similar companies selected based on their industry, size, growth, and various financial metrics.
The comparable analysis method works under the assumption that similar companies should trade at similar valuation multiples. Below is an example of Apple's comparable analysis summary using different EBITDA multiples. According to the model, Apple's fair value is equal to $82.44, representing a -31% downside from the current price of $119.03.
Source: Finbox Peers Valuation Model Summary (You can access the full model for free here)
Among the various valuation techniques used for valuing a business, the dividend discount model is another reliable method that is used to predict the value of dividend-paying companies. The Dividend Discount Model is based on the assumption that a stock's fair value is equal to the sum of its future dividends discounted back to the present.
Below is an example of Apple's dividend discount model (stable growth) summary. According to the model, Apple's fair value is equal to $85.34, representing a -28% downside from the current price of $119.03.
Source: Finbox DDM Model Summary (You can access the full model here)
The precedent transaction valuation method attempts to estimate a business’s fair value by analyzing the price paid for the acquisition of similar companies in past M&A transactions. In this way, the analyst can estimate what a share of the company’s stock is going to be worth during an acquisition.
The precedent transaction valuation is very similar to the comparable companies analysis—with both approaches, the company's fair value is estimated by comparing its valuation multiples to other businesses. While both involve a relative valuation approach, the main difference is that with peer analysis the analyst takes into consideration current valuation ratios, while in precedent transactions the analyst should also consider a takeover premium.
For obvious reasons, one of the most important factors when using this valuation method is identifying relevant precedent transactions, which in some industries don't take place very often. Furthermore, one more difficulty consists of finding reliable information on precedent M&A transactions and creating a reliable estimate on premiums and multiples.
One of the most effective ways to summarize the different estimates obtained using all the valuation methods is to develop a football field chart. It is called a football field chart because the bars used on the chart resemble the yard lines on a football field and because bankers tend to like making sports analogies.
The main goal of using this method is to summarize and sanity-check various methodologies and see how they compare to each other. The purpose of the football field chart is to show just how much a potential buyer will be ready to pay for a particular business, whether they are acquiring a single share, part of it, or all of it.
Below is an example of Apple's football field chart showing the various fair value estimates we obtained using different valuation methods. According to the models, the average of Apple's fair values is $87.14, representing a -27% downside from the current price of $119.03.
Source: Finbox Apple's Football Field Chart (You can access it for free here)
The cash flow statement, or statement of cash flows, is one of the main financial statements of a business that shows its cash expenses and gains over a specific fiscal period. Public companies operating in the United States are required by law to provide their cash flow statement at the end of every quarter and fiscal year.
Now that you know what a cash flow statement is, let's take a look at a real example of a cash flow statement. Here's an example of Apple’s cash flow statement, or statement of cash flows, for the years 2018–2020.
Source: Apple's 10K, Oct 30, 2020
As depicted from Apple's cash flow statement below, cash flow from operating activities is the first section of the statement. Operating activities and cash from operations are those associated with the production and sales of the company's goods and services.
Source: Apple's 10K, Oct 30, 2020
The second section of the cash flow statements consists of cash flow from investing activities, which are those related to the acquisition or disposal of long-term assets and other securities.
As depicted in Apple's cash flow statement below, examples of cash from investing activities include payments made for the acquisition of property, plant, and equipment (PP&E), proceeds from sales of marketable securities, and other financial securities.
Source: Apple's 10K, Oct 30, 2020
Cash flow from financing activities is the last section of the statement. Financing activities consist of cash flows impacting the company's equity or debt structure, such as the issuance of common stock or debt. As shown in Apple's statement below, shares buybacks and dividend payments are also included in cash flow from financing activities.
Source: Apple's 10K, Oct 30, 2020
Companies can choose to produce the cash flow statement using both the direct or the indirect method. The difference concerns the presentation of the operating activities section. The financing and investing sections are identical.
Under the direct method, cash flows from operating activities are presented as a plain list of cash flows. In contrast, the indirect method begins with net income and adjusts the result by adding back non-cash expenses and subtracting non-cash gains. Despite the different types of calculation, cash flows from operations will be the same with both methods.
One of the most important points that investors should always keep in mind is that not all earnings are created equal. As discussed in this lesson about the Sloan Ratio, The most important accounting financial boards require companies to report their revenues and expenses based on accrual accounting.
Following the accrual accounting method, companies record earnings and costs when transactions occur and not when they receive or deliver the cash. Thus, a firm's net income includes many accruals, which are non-cash earnings.
As you can guess, if the company does not receive any cash, it will not have the money to invest and grow. The cash flow statement is so important because it allows investors to analyze the true profitability of a company.
]]>The income statement, or profit and loss statement, is one of the main financial statements of a business that shows its profit or loss for a specific period. Public companies operating in the United States are required by law to provide their income statement at the end of every quarter and fiscal year.
The income statement starts with a company's revenue and ends with its net profit after subtracting operating and non-operating expenses, such as cost of goods sold or SG&A (Selling & Administrative expenses). Having a complete understanding of the income statement is essential for investors to analyze a company's long-term outlook.
Now that you know what an income statement is, let's take a look at a real example of an income statement. Here's an example of Apple’s income statement, or consolidated statement of operations, for the years 2017–2019.
Source: Apple's 10K, Oct 31, 2019
As discussed above, the income statement starts with a company's revenue and ends with its net profit after subtracting operating and non-operating expenses. Here, we'll analyze what goes on an income statement and discuss the various income statement items.
Sales/Revenue
Revenue is the top-line of the income statement and represents the company's income from sales of goods or services before subtracting any kind of expenses. If a company generates sales from different sources, it can list them in the income statement, as Apple does:
Source: Apple's 10K, Oct 31, 2019
Cost Of Goods Sold (COGS)
The cost of goods sold line, or cost of sales, represents the total costs of manufacturing the products sold by the company. It includes items like labor and raw materials.
Gross Profit or Gross Margin
The gross profit is equal to revenue minus cost of goods sold. It is also known as gross margin, as you can see in the Apple statement below. This may generate some confusion for novice investors since the term gross margin is also used to indicate a company's gross profit margin as a percentage of revenue.
Source: Apple's 10K, Oct 31, 2019
Operating Expenses
Operating expenses represent the costs incurred by a company to run its core operations. The most common operating expenses are SG&A expenses (Selling, General & Administrative expenses), that consist of non-manufacturing costs like marketing, accounting, human resources, and more. Another typical operating expense is R&D (Research & Development), which consists of costs to design new products, technologies, or services.
Source: Apple's 10K, Oct 31, 2019
Non-Operating Expenses
Non-operating expenses are costs that are not related to a company's core operations. Interest expense is one of the most common non-operating expenses.
Income Tax
The income tax line represents the total amount of taxes paid by the company during a specific period.
Source: Apple's 10K, Oct 31, 2019
Net Income
Net income, or net profit, is what remains for the business after subtracting all costs and taxes.
Apple's income statement that we've just analyzed is a multi-step income statement. A multi-step income statement categorizes a company's expenses into different groups based on their nature. Public companies operating in the United States are required by law to use a multi-step income statement since it provides the most accurate analysis of the business.
While a multi-step income statement categorizes a company's expenses into different groups based on their nature, a single-step income statement gets to a company's net income with a simple formula that subtracts all the expenses from the company's revenue.
It is no secret that stocks are the best performing asset over the long-term. The stock market helps investors generate income, build wealth, and protect it from inflation. Like any other investment, knowing which type of stocks to invest in and which ones to steer clear of can make the difference between earning a profit and losing your life’s savings.
Many novice investors are inclined to believe that penny stocks are a great way to make money in the stock market. So, what are penny stocks? Can you make money in penny stocks? In this article, we'll discuss if penny stocks are a viable asset to build wealth in the stock market or a speculative one that it would be better to avoid.
By definition, penny stocks are securities trading for lower than $5.00/share. They are usually offered by new companies with a small market capitalization that are typically traded over-the-counter (OTC) and not listed on any major exchanges.
Penny stocks fluctuate significantly within short periods of time due to the lack of volume and liquidity. Many novice investors believe they could take advantage of this volatility to make a significant profit in a short period of time. But, as most of them soon realize, this is easier said than done.
So, can penny stocks make you rich? More often than not, the answer is no. While shares of small companies tend to be a lot cheaper than what’s traded on major exchanges, this doesn't mean they can generate a significant profit quickly.
One of the most common mistakes that investors in penny stocks make is thinking that their low price means that the company has the potential to grow. In reality, this is seldom true.
Most small businesses offering penny stocks are just largely unproven companies with suspicious and bloated long-term prospects for success and are usually the vehicle for market manipulators to weasel inexperienced investors out of their hard-earned money.
Let's discuss a few other reasons why you can’t expect to get rich off penny stocks.
As discussed above, penny stocks are usually the vehicle for market manipulators to weasel inexperienced investors out of their hard-earned money through a variety of stock market frauds, such as:
Chop stocks are securities bought by a disreputable broker for pennies and sold to inexperienced investors for dollars. While the broker ends up making a considerable profit, investors purchase stocks of companies that are usually not worth a penny.
That's exactly what happens in the movie The Wolf Of Wall Street with Jordan Belfort, the legendary stockbroker who made millions trading chop stocks. The following scene from the movie gives a good idea of the way he did it.
Pump and dump schemes consist of buying a stock, spreading fake or misleading news to pump its price, and then dump it to inexperienced investors at the highest price possible.
This is due to the lack of volume and liquidity of penny stocks, making it easy for market manipulators to put such unethical practices in place.
Although penny stocks can even double in price in a few days, that would not be enough to cover their expensive trading fees, which could be even higher than the stock price. So, even if a penny stock is trading for a few cents, investors could end up paying way more than that.
Most companies offering penny stocks don't meet the requirements to be listed on the major stock market exchanges, so they are not required to follow their rigorous financial standards. For instance, the regular bid price at the time of listing on Nasdaq must be $4.00, and there must be at least three market makers for the stock (source).
The lack of financial information should always be a major red flag for investors since there is no way of getting accurate or reliable information on the financial status of a company offering penny stocks.
]]>By definition, the weighted average cost of capital (WACC) is the average after-tax cost of a company's various capital sources. These include preferred stock, common stock, bonds, and long-term debt. So, as the name implies, WACC is the average rate that a company pays to finance its assets.
Since almost every business needs to raise capital to grow, WACC is one of the most important financial indicators. It represents the expense of raising money—so the higher it is, the lower a company's net profit. For instance, a WACC of 10% means that a business will have to pay its investors an average of $0.10 in return for every $1 in extra funding.
So, now that you’ve got an idea of what it is, let's see how to calculate WACC with the right formula. WACC is calculated by multiplying each capital source's cost by the corresponding weight and by adding the products together to get the weighted average cost of capital.
Obviously, the more complex the company’s capital structure is, the more complex the WACC calculation. The main capital sources of most publicly traded companies are usually debt and common stocks. Here's the WACC formula:
WACC = E/TC*Re + D/TC*Rd*(1 – Tax Rate)
As an example calculation, we can use the formula above to calculate Apple's (NASDSAQGS:AAPL) weighted average cost of capital. Using the Finbox data explorer, we can find the values of the metrics required to apply the formula:
We can now perform a WACC example calculation for Apple:
Apple's WACC = Apple's Equity (% Of Total Capital) * Apple's Cost Of Equity + Apple's Debt (% Of Total Capital) * Apple's Cost Of Debt
= 94.4% * 8.32% + 5.6% * 4.5%
= 8.1%
You can calculate WACC for every single company in the world using this automated template. Using the Finbox Spreadsheet Add-On, you just have to enter the ticker of the company whose WACC you want to calculate and the model will do everything automatically.
Here's a preview of Finbox's WACC Calculator:
As of October 16, 2020, the sectors with the highest WACC are healthcare, energy, and materials. Utilities, financials, and real estate are the sectors with the lowest WACC.
Pro Tip: You can get up-to-date stats and graphs like that one directly in Excel/Google Sheets using this model following the instructions inside.
If you try searching "what is a good WACC" on Google, you will find a wide range of answers. One way to easily determine a good WACC is to look at the sector average. As you can see in the picture above, the weighted average cost of capital varies considerably from one sector to another, ranging from more than 10% for healthcare to 7% for utilities.
That's because investors and lenders consider utility stocks less risky than the market, so they require a lower rate of return to finance those companies with both equity and debt.
As a rule of thumb, a good WACC is one that is in line with the sector average. When investors and lenders require a higher rate of return to finance a company it may indicate that they consider it riskier than the sector.
]]>The Capital Asset Pricing Model (CAPM) is a model used to calculate the cost of equity for a company based on its risk, represented by its stock's beta. From an investor’s perspective, CAPM is used to calculate the expected return of a stock investment. According to this theory, the only way an investor can earn above-average investment returns is to invest in riskier securities.
In short, CAPM is a model that is used in the financial sector to help describe the relationship between the expected risks and returns of an investment. While many investors raise doubts about the CAPM model, it is still widely used in the finance sector.
According to the Capital Asset Pricing Model (CAPM), a company's cost of equity is equal to:
Cost Of Equity = Rrf + [β x (Re – Rrf)]
Where:
Let's break down each of the formula's components:
To illustrate, we can calculate Netflix (NASDAQGS:NFLX)'s cost of equity using the CAPM formula. With the Finbox data explorer, we can find the values of the metrics required to apply the formula:
Here's Netflix's cost of equity (expected return) calculation using the CAPM formula:
Cost Of Equity = Risk free rate + Beta*Equity Premium
Cost Of Equity/Expected Return = 0.70% + 0.97*5.5% = 6.03%
You can calculate CAPM and WACC for every single company in the world using this automated template. Using the Finbox Spreadsheet Add-On, you just have to enter the ticker of the company whose score you want to calculate and the model will do everything automatically.
Here's a preview of Finbox's CAPM Calculator:
Although the Capital Asset Pricing Model is widely used in financial modeling to evaluate the intrinsic value of a business, it has some serious drawbacks. Like most theoretical models, CAPM doesn't actually reflect reality. So let's discuss some of its disadvantages:
1# βeta Is Not An Objective Metric
As discussed above, a stock's beta is equal to the volatility of its price changes compared to the market. If we select different periods, we'll get different betas, resulting in an inconsistent investment risk valuation.
For example, here are Apple's βeta for different periods:
As you can observe, two analysts using different βetas will obtain different results.
2# Volatility Isn't Risk
One of the Capital Asset Pricing Model's main assumptions is that a stock's volatility represents the investment risk. But this statistical approach often doesn't reflect reality. Let's consider Apple (NASDAQGS:AAPL)'s stock as an example.
Source: Finbox Fundamental Chart Editor
As depicted above, Apple is one of the few outperformers of the COVID-19 pandemic. Its stock price skyrocketed at the expense of its valuation metrics, resulting in a tremendously overpriced stock. A more expensive stock usually equals a riskier investment, right?
Nevertheless, Apple's 1-year Beta is much lower than the corresponding 5-year metric. So, according to the Capital Asset Pricing Model, Apple's stock is now less risky than the past. Of course, Apple's valuation tells a completely different story.
]]>By definition, a balance sheet is a financial statement of all of the company's assets (what the company owns) and liabilities (what the company owes) along with the value of the shareholder's equity (a company's net worth) for a specific period. It is known as a balance sheet because it is maintained to ensure that a company's assets are always equal to the sum of liabilities and shareholders' equity.
A balance sheet is also commonly known as a statement of financial position or statement of net worth. By analyzing the statement, investors can get a snapshot of the company's financial situation at any given time. Companies can prepare the statement on a monthly, quarterly, or annual basis.
Now that you know what a balance sheet is, it's time to find out what goes on a balance sheet. Let's take a look at an example of Apple's 2019 balance sheet.
As you can see, it begins with Current Assets, followed by Non-Current Assets and Total Assets. Then there are Liabilities plus Stockholders' Equity with Current Liabilities, Non-Current Liabilities, and, lastly, Shareholders' Equity.
Source: Apple's 10K, Oct 31, 2019
As already discussed, the balance sheet is usually divided into two sections: assets and liabilities plus shareholders' equity. All the balance sheet items are sorted based on their liquidity—most liquid assets, such as cash, come first.
Assets are typically recorded on the left-hand side of the balance sheet and divided into current assets and noncurrent assets, while liabilities are grouped into current liabilities and non-current liabilities. The shareholder's equity section includes information on common stock, retained earnings, accumulated other comprehensive income, and treasury stock.
At the bottom, the value of total assets and that of total liabilities plus shareholder's equity should be equal. Every balance sheet also includes notes and footnote disclosures, which will offer crucial information regarding a company's financial situation, including potential liabilities not included in the balance sheet.
Current assets are assets that the company expects to sell or use over the next year. They consist of the most liquid assets, such as:
Cash and Cash Equivalents
Being the most liquid asset, cash is the first item on the balance sheet, along with cash equivalents, which consist of holdings with short-term maturities or that the firm can liquidate quickly, such as marketable securities. Investors can find further information about cash equivalents in the footnote disclosures.
Accounts Receivable
Accounts receivables are sales made on credit, whose cash has not yet been collected by the company. When the firm receives the cash, accounts receivable decrease, while cash increases by the same amount.
Inventory
Inventory consists of finished goods not yet sold and raw materials used to produce them.
Non-current assets are assets that the company doesn't expect to sell or use over the next year. They consist of less liquid assets, such as:
Property, Plant, and Equipment (PP&E)
Property, Plant, and Equipment (PP&E) consist of the business’s tangible fixed assets. Some businesses further classify their PP&E based on the different natures of assets (for example land, buildings, etc...).
Intangible Assets
Intangible assets are assets that are non-physical, such as trademarks or copyrights. Companies can also categorise intangible assets into two different groups: identifiable intangible assets, that include patents or licenses, and unidentifiable intangible assets, such as brand recognition or goodwill.
Current liabilities are obligations that must be paid over the next year. For example:
Accounts Payable
Accounts payable are payments owed to suppliers for purchases made on credit.
Current Portion of Long-Term Debt
This is the portion of long-term debt (with a maturity greater than one year) that is due within the current year. For instance, if a firm has a 10-year loan, this account includes the portion of the loan owed in the current year.
Non-current liabilities are long-term obligations that are not due within the upcoming year. They include:
Bonds Payable
This account includes the amortized amount of any bonds the company has issued.
Long-Term Debt
This account includes the total amount of long-term debt (excluding the current portion, if that account is present under current liabilities). This account is derived from the debt schedule, which outlines all of the company’s outstanding debt, the interest expense, and the principal repayment for every period.
Shareholders' equity, also known as Stockholders’ Equity or Net Worth, consists of the funds with which the company has been financed. The main sources of funds for shareholders' equity are:
Share Capital
Share capital consists of the amount of money invested by stockholders. If an entrepreneur starts a company investing $1 million, cash (asset) grows by $1 million, and share capital (on the shareholders' equity) goes up by the same amount.
Retained Earnings
Retained earnings is the portion of net income retained by the company.
Now that we have broken down what is included in a balance sheet, let's discuss what a balance sheet analysis can tell investors:
Liquidity Analysis: Investors can analyze a company's liquidity by comparing current assets to current liabilities. If the company's liquidity is not good enough, it could face severe difficulties in paying its current debts if its daily income stops (as in the case of a pandemic). The consequences would be even more severe in the event of a credit crunch (i.e., a sudden reduction in the general availability of loans.)
Solvency Analysis: Analyzing how a company is financed can help you evaluate the ability of a company to pay its long-term debt and the interest on that debt. A financially strong company has enough liquidity to pay its short-term obligations and, at the same time, must manage its capital structure appropriately.
Efficiency Analysis: Investors can analyze a balance sheet together with the income statement to evaluate how efficiently a business utilizes its assets. For example, the asset turnover ratio, which is equal to revenue divided by total assets, is used by investors to measure how efficiently a company is using its assets to generate revenue.
As discussed above, the statement of financial position is also known as a balance sheet because it is maintained to ensure that a company's assets are always equal to the sum of liabilities and shareholder's equity. Here's the balance sheet formula:
Assets = Liabilities + Equity
The balance sheet equation states that the sum of liabilities and owner's equity is equal to the total assets owned by a company.
]]>By definition, the time value of money is a simple concept that money available in the present is worth more than the same amount of money in the future. It can be easily explained with an example:
If you get paid $2.000 for a job, you can invest the money, earn a 10% interest rate, and have $200 more in your bank account after one (1) year. If your client pays you one (1) year late, you will lose $200. That's why $2.000 now is worth more than the same amount of money one year from now.
Inflation is an important factor when it comes to the time value of money because it tends to erode the purchasing power of money over time. For instance, the price of a gallon of gasoline today is more than doubled than twenty (20) years ago, which means you could have purchased a lot more gasoline for the same amount of money than you could today.
Source: Statista
This is the main reason why both purchasing power and inflation needs to be factored in when you are thinking about investing your money. To calculate the real return on your investment, you have to subtract the inflation rate from the internal rate of return (IRR) of your investment. If the inflation rate is higher than the annualized investment return, you lose money even if you get a decent nominal return.
So, now that we’ve got a grip on the time value of money concept, let’s take a look at the formula that is used by individuals and businesses who want to make sure they have made the right investment decision. A formula that can be used for calculating the future value of money to compare it to the current value of money is:
FV = PV x [1 + (I / n)] (n x t)
Here's a breakdown of the individual components of the formula:
The future value of $50,000 invested for one year at 8% interest is:
FV = $50.000 x [1 + (8% / 1)] ^ (1 x 1) = $54.000
You can also find the net present value of a future amount. For example, how much did Alex invest one year ago if he gained an 8% interest rate and currently has $10.000?
PV = $10.000 / [1 + (8% / 1)] ^ (1 x 1) = $9,259.26
If you want to dig deeper about net present value, I recommend reading this guide where we discuss everything you need to know about it.
]]>The IRR (Internal Rate of Return) is the compounded annual return an investor can expect over an investment’s lifetime. Financial analysts and investors use it to determine the potential of an investment and evaluate the intrinsic value of a business, investment securities, and more. Although it may seem a bit difficult at first, the IRR is a very straightforward concept. Let's make things clear with an example.
Alex owns a shop in the city center and wants to buy a $10.000 truck that could add $2.000 a year in profit to the business. The truck has an estimated useful life of ten (10) years, after which it must be replaced. Alex could get the funds from a bank with a 4% interest rate.
How does he know if this is a profitable investment? He can calculate the internal rate of return of the truck's investment and check if that's higher than the 4% interest rate! In this article, we'll discuss everything you need to know about it.
Now that we have an idea of the IRR’s meaning, we can move forward and discuss how to calculate the IRR with the right formula to analyze the profitability of a project or an investment. Calculating the IRR manually is not easy. The only way to do that is to try several calculations to get the discount rate that makes the Net Present Value equal to zero (0).
As discussed in the NPV guide, the net present value is the value of the future cash flows of an investment discounted to the present. If you're not familiar with the concept, I suggest reading our NPV guide before continuing with this one.
So the IRR is the discount rate at which the NPV is equal to zero (0). Although it may seem a bit difficult at first, the IRR is a very straightforward concept, and it will become crystal clear once you've read this guide. Let's get back to Alex:
As discussed above, he can invest in a $10.000 truck, which could add $2.000 yearly profit to the business. He could get the fund required from a bank for a certain interest rate. Well, the IRR is the interest rate at which interest expenses would be equal to the investment's revenue. In other words, the IRR is the maximum interest rate at which Kevin can borrow the funds and make a profit from the investment. Any interest rate greater than the IRR would mean a loss for the business.
You can easily undertake an IRR calculation in Excel using the IRR or the XIRR functions. The IRR function assumes that all the cash flow occurs at regular and equal periods, while, with the XIRR function, analysts can specify precise dates for each cash flow and calculate the internal rate of return of potentially irregularly spaced cash flows.
When possible, it's preferable to use the XIRR function since it is much more accurate—let's analyze the example below:
We can observe that the two functions return different values. That's because the IRR function assumes all periods are equal, while XIRR handles the real intervals, which in some years are 366 instead of 365.
Let's discuss other differences and analyze how to apply each function to a real example.
As depicted in the picture above, using the XIRR function in Excel is very straightforward. You just need to set a series of cash flows and dates. Here's the XIRR function breakdown:
XIRR(cashflow_amounts, cashflow_dates)
As depicted above, the IRR function is slightly different—you don't need to select a range of dates since the IRR function assumes that all the cash flow occurs at regular and equal periods. Here's the IRR function breakdown:
IRR(series of cash flow)
As discussed above, Alex owns a shop in the city center and wants to buy a $10.000 truck that could add $2.000 a year in profit to the business. The truck has an estimated useful life of 10 years, after which it must be replaced. Alex could get the funds from a bank with a 4% interest rate.
An internal rate of return calculation can help investors determine whether to take an investment or not given a series of projected cash flows. As shown before, the IRR of 15.10% is greater than the 4% interest rate, making the truck a profitable investment for the business.
The Net Present Value is the value of the future cash flows of an investment discounted to the present, while the IRR (Internal Rate of Return) is the compounded annual return an investor can expect over the investment’s lifetime. IRR is also the discount rate at which the NPV is equal to zero (0). Let's analyze the difference between NPV and IRR with the previous example:
If Alex gets a loan at a 4% interest rate, he will realize a significant gain on the investment because its compounded annual return (IRR) is 15.09%. As you can see, the NPV is greater than zero (0), which means that the investment will add value to the business.
Another way to interpret the NPV is to consider it as the investor's profit after interest expenses. In other words, adding the NPV to the initial investment represents the price at which the investor would obtain zero (0) profit. Any price above that number would mean a loss.
As depicted in the picture below, a cost of capital equal to the investment's internal rate of return means zero (0) profit for the investor.
Did you notice that the net present value is different using the NPV and the XNPV function? Can you spot the difference between the two functions? Learn everything you need to know in this NPV guide!
The Net Present Value is the value of the future cash flows of an investment discounted to the present. Financial analysts and investors use it to determine the potential of an investment and evaluate the intrinsic value of a business, investment securities, and more. Although it may seem a bit difficult at first, the NPV is a very straightforward concept. Let's make things clear with an example.
Alex owns a shop in the city center and wants to buy a $10.000 truck that could add $2.000 a year in profit to the business. The truck has an estimated useful life of ten (10) years, after which it must be replaced. Alex could get the funds from a bank with a 4% interest rate. How does he know if this is a profitable investment? He can use the NPV formula! In this article, we'll discuss everything you need to know about it.
Now that we have an idea of the NPV meaning, we can move forward and discuss how to calculate the NPV with the right formula to analyze the profitability of a project or an investment. The Net Present Value of a series of future cash flows is equal to the sum of the NPV of each cash flow. Here's the NPV equation:
Here's a breakdown of the individual components of the NPV formula:
You can easily undertake a Net Present Value calculation in Excel using the NPV or the XNPV functions. The NPV function assumes that all the cash flow occurs at regular and equal periods, while, with the XNPV function, analysts can specify precise dates for each cash flow and calculate the net present value of potentially irregularly spaced cash flows.
When possible, it's preferable to use the XNPV function since it is much more accurate. The NPV function also has some other limitations that we are going to discuss right away—let's analyze the example below:
First, we can observe that the two functions return different values. That's because the NPV function assumes all periods are equal, while the XNPV handles the real intervals, which in some years are 366 instead of 365.
Let's discuss other differences and analyze how to apply each function to a real example.
As depicted in the picture above, using the XNPV function in Excel is very straightforward. You just need to set a discount rate, a series of cash flows, and dates.
XNPV(discount rate, cashflow_amounts, cashflow_dates)
The NPV function is slightly different and involves an additional calculation if the first cash flow happens at the beginning of the first period.
NPV(discount rate, series of cash flow)
First, you don't need to select a range of dates since the NPV function assumes that all the cash flow occurs at regular and equal periods.
Second, you can't include the initial investment in the function, but you need to perform an additional calculation. As the NPV help page states:
The NPV investment begins one period before the date of the value1 cash flow and ends with the last cash flow in the list. [....] If your first cash flow occurs at the beginning of the first period, the first value must be added to the NPV result, not included in the values arguments.
Let's summarize the differences between the NPV and the XNPV functions.
As discussed above, Alex owns a shop in the city center and wants to buy a $10.000 truck that could add $2.000 a year in profit to the business. The truck has an estimated useful life of 10 years, after which it must be replaced. Alex could get the funds from a bank with a 4% interest rate.
A net present value calculation can help the investor determine whether to take an investment or not given a series of projected cash flows and the cost of capital. Here's the net present value calculation for the truck:
First, you need to evaluate if the net present value is positive or not. A net present value greater than zero (0) means that the investment will add value to the business.
Another way to interpret the NPV is to consider it as the investor's profit after interest expenses. In other words, adding the NPV to the initial investment represents the price at which the investor would obtain zero (0) profit. Any price above that number would mean a loss.
IRR (Internal Rate of Return) is the compounded annual return an investor can expect over the investment’s lifetime. IRR is also the discount rate at which the NPV is equal to zero (0). Let's analyze the difference between NPV and IRR with the previous example:
If Alex gets a loan at a 4% interest rate, he will realize a significant gain on the investment because its compounded annual return (IRR) is 15.09%. As you can see, the NPV is greater than zero (0). As long as Alex can get a loan with an interest rate lower than 15.09%, the investment will add value to the business. As depicted in the picture below, a cost of capital equal to the investment's internal rate of return means zero (0) profit for the investor.
Did you notice that the internal rate of return is different using the IRR and the XIRR function? Can you spot the difference between the two functions? Learn everything you need to know in this IRR guide!
As you learned in the dividend yield lesson, dividend stocks with the highest yield have historically underperformed compared to those with a lower one because high dividend yield stocks usually come with higher risk.
Indeed, while a high yield seems attractive to investors, an unsustainable distribution to shareholders can lead to a dividend cut and a drop in the stock price.
In this lesson, you will learn how to recognize an unsafe dividend before it's too late with six metrics that will help you determine if a firm’s distributions to shareholders are sustainable in the long run.
The dividend payout ratio is a popular metric that tells you the percentage of earnings that a business distributes to shareholders as dividends. It is equal to the total dividends paid to shareholders divided by the latest twelve months' net income.
Dividend Payout Ratio = Total Dividends / Net Income
With a dividend payout ratio higher than one (1), the company pays shareholders more than it earns. It is a big warning sign that could foreshadow a dividend cut and a stock price crash.
However, the company's cash flow may be greater than earnings, and the dividend may be safe despite a high payout ratio. To make sure that this is the case, you can look at the dividend coverage ratio.
The dividend coverage ratio is a less popular financial ratio that measures how many times a firm's cash flow from operations covers the dividend. If a company makes $20B in operating cash flow and distributes $10B in dividends, the coverage ratio is 2x.
Dividend Coverage Ratio = Operating Cash Flow / Total Dividends
While earnings represent only a number on the income statement, the company can't pay any dividends if it doesn't have the cash to do that. Thus, it is worth using the dividend coverage ratio to make sure that a business can handle its dividend with ease and that you're picking the right dividend stocks.
One of the most important investing rules is to always do your own research and never base your investment decisions on what others say about a particular stock.
However, overconfidence and confirmation bias could lead you to make bad investment decisions. Thus, it could be very helpful to take a look at analysts' forecasts and double-check that you didn't miss anything.
As you can see in the picture below, you can use the Finbox Data Explorer to access dividend per share forecasts for 100,000+ stocks worldwide. If you find dividend stocks with a forecast like Coca-Cola (NYSE:KO), you have the confirmation that analysts are very bullish on the companies' dividend.
While analyzing dividend stocks, it could be very helpful to look also at a company's debt. How can a company pay dividends if it doesn't have enough money to sustain its debt?
The interest coverage ratio is a debt ratio that measures how easily a firm can pay interest on outstanding debt with its available earnings. It is equal to a company's earnings before interest and taxes (EBIT) divided by its interest payments owed in the corresponding period.
Interest Coverage Ratio = EBIT/Interest Expense
With an interest coverage ratio lower than 1.5, a company's ability to meet interest payments and dividends should be questioned.
The cash flow to total debt ratio is another popular financial metric used by investors to evaluate a company's ability to handle its debt with its operating cash flow.
Cash Flow / Total Debt = Operating Cash Flow / Total Debt
You can use this metric to measure how many times a company's operating cash flow covers its debt. Another way to use it is to invert the formula and see how many years it would take the company to pay off its debt.
In his book, What Works On Wall Street, James O'Shaughnessy divided the entire U.S. stock market into ten (10) deciles based on cash flow to total debt. Not surprisingly, companies with low cash flow to total debt drastically underperform the market.
In the 45-year backtest period from 1964 to 2009, stocks in the lowest decile for cash flow to total debt posted a 2.41% CAGR compared to the 11.22% CAGR of the whole market.