Pros and cons of economic value added

Effect of regulation on Economic Value Added

Image attribution: Mgmwki; CC BY-SA 3.0

Economic Value Added (EVA) is a term referring to financial gain in excess of profit expectations. In other words, EVA  measures the extra value profits yield for an organization after deducting cost of capital such as dividends to shareholders. Although EVA is an acronym used across multiple industries with different meanings, its significance in finance is specific. Moreover, the usage of EVA often refers to a proprietary version of the calculation claimed to have been created by the Business Advisory Firm Stern Stewart & Co in the late 1980s.

Uses

The EVA metric is primarily used as a business valuation tool. Some proponents of EVA such as P.C. Narayan of the Indian Institute of Management at Bangalore advocate EVA over other profitability metrics because it demonstrates potential future earnings. This according to Narayan, is because measurements such as Earnings Per Share (EPS) only provide a snapshot of how well a company has met stock-holder's past financial expectations and does not reflect potential for capital reinvestment.

Calculation

In terms of the Stern, Steward & Co. formula, EVA is the result of subtracting taxes and weighted average cost of debt and equity capital from net operating profit. This however, is not the only way to determine EVA because the cost of capital calculation varies between businesses. For example, the United States Postal Service version of EVA indexes its operating cost to inflation to more accurately reflect costs after rate increases. Other companies may not need to adjust costs to inflation based on corporate policies and accounting methods. The Stern Steward  & Co EVA formula is shown below:

EVA= (Net Operating Profit-Tax)-(Weighted Average Cost of Equity and Debt)

Advantages

The advantages of EVA are it supplements financial data from other methods of business assessment and valuation. Moreover, it reflects businesses' cost management and demonstrates availability working capital after its original opportunity cost has been deducted. Another benefit of EVA is it can be used as a managerial incentive that helps assure the continued performance of a business. It also evades problems associated with percentage calculations by using specific values according to Aswath Damodaran, a Finance Professor at the New York Stern School of Business.

Disadvantages

Economic value added cannot measure how well capital asset managers utilize retained earnings via project management and other business ventures. Moreover, capital asset managers may squander liquid reserves instead of effectively increasing the future return on capital by  reinvesting it with the aim of lowering operational costs via profitability instead of cost cutting. Economic value added also cannot valuate return on expenses such as research and development. Moreover, despite being an income statement operating expense, research and development actually has the potential to yield  future earnings not measured by EVA.

Guest post: A personal review of Barron's Magazine - Reasons to unsubscribe from Forbes

By: James Geddens

I have recently cancelled by subscription to Forbes Magazine and have instead started subscribing to Barron’s Magazine, simply due to the fact that I found it hard to keep up with some of the analysis.  The editorial articles inside Barron’s are extremely well authored and offer a superb perspective on what happened during the prior week’s financial world.  It also includes sections which tell you what is going to be happening during the following week’s stock market trading.

Get the Latest Stock Market Prices & Tables

The Market Laboratory pull out section is essential too because this includes all the latest stock and bond prices for the next 7 days, although it can be a little bit too in-depth and you can tend to get this detail off the web anyway.  However, it’s still handy to have all the stock tables in front of you as one easy read.  Since making the switch from Forbes I have found that I have actually been able to read every single weekly edition of Barron’s.  It makes a change to having magazine piled up on my desk that I never get around to reading! 

Get Invaluable Investment Leads Like the Professionals Do

One of the other reasons that I subscribe to Barron’s Magazine is that I like to know what the business leaders are reading.  According to research, the average worth a Barron’s reader is $3 Million US Dollars.  Whilst I don’t have that much money, it’s still pretty cool to know that I can benefit from the same investment leads that those guys get each week.  Over the course of my subscription to Barron’s I have seen my own stock portfolio’s value rise by 21% as I owe a lot of that down to the advice that I get inside the different pages by the expert columnists.  A lot of the commentary in the magazine is also quite humorous and makes a change from the rather staid and stuffy reporting seen in rival publications. 

Value for Money with Up to Date Finance News

Barron’s Magazine might be quite expensive but it does come weekly which make the annual $99 Dollars subscription fee offer value for money in my view.  If you are an investor like me then you will already be aware of the importance of getting the most timely financial information – and Barron’s certainly seems to offer that.  Whether you want to know the latest oil prices, details on the latest corporate takeover, or what’s hot or not in finance, then it should tick all the boxes for you. 

No Over the Top Advertising Space

Another plus point to Barron’s is the fact that it does not have large and over the top advertising space on any of the pages.  There are a few ads, but these are always placed contextually and don’t interfere with your reading.  The ads usually blend quite well into the articles so you almost tend not to notice them. 

It’s Like Forbes Magazine but Without the “Fluff”

How I like to describe Barron’s Magazine, is that it is like the Wall Street Journal or Forbes… but without all the fluff.  You can either subscribe to it via post in traditional magazine format, or get it via email with a login to the Barrons.com website.  In the most simple terms possible I would say that Barron’s Magazine is a must read for people who love stock market numbers.  If you want to keep ahead of the competition and make better investment choices and picks then it could work for you.  Personally I love it and could not do without it nowadays. 

Author Bio: James Geddens is a 32 year old investment trader based in New York who reads Barron’s Magazine each week.  If you want to know more about Barron’s then you should click here for more info on this independent subscriptions website that hosts information about most financial magazines.

Why the price-to-earnings ratio is not an adequate valuation metric

The price to earnings ratio is often used as a measure of corporate performance and overall market performance via the P/E ratios of whole indexes. If the ratio is low in comparison to previous levels then the market is sometimes believed to have room to rise even if it is already inflated. For example, market analysts and observers such as StockCharts.com illustrate this point. Moreover, since 82 percent of companies that reported Q4, 2011 earnings had GAAP vs Operating P/E ratios that were in-between 15 month highs and lows, then those companies are believed to be fairly valued per Stock Charts.

Even GAAP or Generally Accepted Accounting Principle Price to Earnings ratios can be misleading however. This is because it measures earnings and not revenue. Earnings are what are left after a company deducts outflows such as expenses, and dividends. So if revenues decline quarter after quarter, but earnings rise relative to price via cost cutting, then it will appear as though the company is becoming cheaper. For example, ABC Corporation earns $100 million on 5,000,000 shares in Q3, 2011 and has a share price of $300 giving it a P/E ratio of 15. Then in Q4, 2011 ABC Corporation increases earnings to $125 million by laying off 625 workers at 40k/yr; the price rises to $325/share and the P/E ratio drops to 13 making it seem undervalued.

Clearly the above corporation is questionable investment if it has to lay more people off to stay profitable. The price to earnings ratio does not measure underlying financial conditions.  But that's not all, if cost cutting has already been tried, and that option is no longer available because it would actually cause earnings to decline, ABC Corporation can also reduce the P/E ratio by purchasing existing shares or issuing new shares if the price per share declines. To illustrate,  if ABC corporation purchases 1,000,000 shares in Q1, 2012 and both earnings and share price remain near their $125 million and $325 levels, the P/E ratio then drops even more to 10.4. All the company did was shrink its own shares outstanding.

How To Interpret Bond Yield Curves

Yield curves are the percent return on investment offered by financial instruments such as bonds. Bond yield curves are important indicators of economic activity, risk, monetary policy and market conditions. Consequently, bond yield curves are useful in financial analysis. For example,  bond rating and yield indicate the quality of the bonds, and the angle at which the yield curve slopes indicates how risky longer-term bond issues are perceived to be. Understanding what bond yield curves mean can help investors with assessing risk and in arriving at investment decisions such as which bonds, if any to invest in.

Duration

The length of time until a bond's face amount becomes due to the buyer is called the duration. Generally, with longer durations, the yield of a bond goes up because the opportunity cost and investment risk rises with time. It is for this reason that yield curves tend to curve upward, however the slope of these curves can either be low or high depending on the issuer's credit rating. For example, the U.S Treasury Bond yield curves below are from the Federal Deposit Insurance Corporation (FDIC) and show a higher yield for 30 year bonds than they do for 6 month bonds.  More up to date bond yield curves can be viewed at the U.S. Department of the Treasury.

U.S. Treasury Security Yield Curves

 Source: FDIC US-PD

Classification

The kind of bond also affects the bond yield curve. As evident in the above bond yield curve graphs, conventional bond yield curves are placed higher than the Treasury Inflation Protected Securities or TIPS. This is because investors are willing to pay in the form of lower yield for the inflation protection of security that is not offered by conventional bonds according to the Wall Street Journal. Moreover,  when the demand for TIPS is higher, then the yield will be lower. The reason the yield isn't higher regardless of demand is because the inflation protection is not incorporated into the yield, but rather the principal balance according to Treasury Direct.

Issuer

Bond yield curves also differ by bond issuer. For example, a country with a high credit rating is more likely to have lower bond yields, and a flatter bond yield curve due to the low-risk associated with those bonds. However, if an economy is performing badly, the affect on bond yields tends to be toward higher yields and more vertical curvature. This is evident in recent rises to Italian and Spanish bond yields after being downgraded by Standard and Poor's per Reuters. In other words, with lower-risk bond issues, price rises with demand, but the yield curve then moves down. 

Risk

Market risk also affects bond yields. To illustrate, consider an especially highly rated bond; these are thought to be a financial safe haven or low-risk investments for large institutional investors, sovereign wealth funds and individual investors seeking to lower investment risk via diversification into bonds. If other investments seem too volatile for investors, they may invest a larger amount into bonds because of their safety. The affect of this increased investing on the bond yield curve will be  a downward movement of the whole curve where the longer-term issues still curve up, but at lower yields due to increased demand.

Policy

Bond yield curves can also reflect monetary policy. A good example of this is the Federal Reserve Bank's bond buying programs. Quantitative easing as it is also known adds money to the financial system because the central bank purchases more bonds. This causes the Federal Reserve's assets to increase, and also puts downward pressure on the bond yield curve. Another example of this is the Federal Reserve Banks' 'Maturing Extension Program and Reinvestment Policy' or selling of short-term Treasury Securities and buying of long-term ones. This causes the yield curve to flatten at the back end and become more horizontal which subsequently demonstrates the influence of monetary policy on the bond yield curve.

How to use the Dupont Identity to analyze business performance

The Dupont identity is a financial analysis tool used to assess the performance of corporations. According to FCS Commercial Financial Group, an advantage of the Dupont identity is it allows more in depth assessment than a single profitability ratio. This is because the formula evaluates corporate profit in terms of assets, equity leverage and actual sales figures rather than sales forecasts. When calculating the Dupont Identity, two equations are used; one is used to evaluate return on assets, and is a sub-component of the second that ultimately determines business profitability.

Components

The three component parts of the Dupont Identity per the FCS Commercial Financial Group include return on equity, total asset turnover and the equity multiplier. These are three financial ratios that are also individually used in financial analysis. The first of these ratios determines profit margin or the percentage earnings of total revenue. The second ratio demonstrates how well a company's assets are being used in terms of generating revenue. The equity multiplier shows how much assets a company has in terms of equity capital.

1. Profit Margin: Profit/Sales
2. Total asset turnover : Sales/Assets
3. Equity multiplier: Assets/Equity

Equation(s)

The first of the two equations determines a businesses return on assets or ROA by multiplying profit margin by total asset turnover.

1. Return on Assests= Profit margin x total asset turnover

The second equation of the Dupont identity determines return on equity (ROE) by mulitplying ROA by equity leverage.

2. “Extended” DuPont Identity= Profit margin x total asset turnover x equity multiplier

Example:

A Securities and Exchange Commission corporate filing by Walmart Stores, Inc. had a July 31, 2011 quarterly profit of $3.801 billion on sales of $109.366 billion with total assets valued at $193.656 billion and equity of $67.941 billion. With these numbers the component parts of the Dupont formula can be calculated.

1. Profit margin= profit/sales= $3.801 billion/$109.366 billion =3.475%
2. Total asset turnover= sales/assets= $109.366 billion/$193.656= 56.47% (1.77 x sales)
3. Equity multiplier= assets/equity= $193.656 billion/$67.941= 2.85
   
Since Total Asset Turnover is expressed as a multiple of sales rather than the result of division, multiplying 1x2= 6.151%. Therefore, the result of the DuPont equation is which is 6.151% x the equity multiplier of 2.85 = 17.529%

The higher the extended Dupont identity is, the better a corporation is performing. This method of calculating corporate profitability enables analysts to more accurately determine the cause(s). For example, if the total asset turnover ratio is high, but profit margin and the equity multiplier are low, then it indicates strong use of assets and capital but high operational costs. 

In the case of Walmart, a strong aspect of the businesses performance seems to be derived from its total asset turnover and high equity leveraging than profit margin. This means the company makes good use of investor capital and sells a high percentage of product, but with minimal profit on each individual sale.

Benefits of Using Microsoft Excel for Financial Analysis

Microsoft Excel does the algebra for you, and the charting, and the graphing and the statistical analysis. All that is required for analyzing financial data using excel is a few minutes to enter the data into s spreadsheet and a little knowledge about which excel tools can be used for financial analysis. This article will discuss some of those software tools and illustrate how they work.

Excel regression and statistical analysis

Regression analysis takes a set of dependent and independent variables such as sales figures and adjustments in marketing budget over 12 months and then calculates a deviation for each of those variables around the mean i.e. average dependent variable. As the independent variable changes i.e. marketing budget, the sales values may fluctuate up or down around the mean which may also rise or fall.

From the above information, excel can then calculate P-Values, betas and alphas can be found using excel which help determine the strength of the correlation between variables in addition to the magnitude changes in the independent variable are matched by the dependent variable. All these results can be charted, plotted and graphed using the regression function in Microsoft excel with just a few minutes of data inputs.

Other statistical analysis can be performed by adding in the Excel data analysis feature and some of the analysis this particular excel toolpack can achieve are the following:

• Covariance: Measures average deviation from the mean
• Correlation: The relationship between two variables
• Descriptive statistics: Includes a wide range of calculation that describe data
• ANOVA analysis: Analyzes and contrasts two information categories
• Ranks and Percentiles: Descriptive statistics that categorize and organize variables

Histograms, scattergrams, pie graphs and bar charts

By entering data into a spreadsheet in excel one is making possible the conversion of that data into graphical display which can lead to a potential host of other benefits. There are several types of graphical and pictorial display of data that can be accomplished using Microsoft excel including the aforementioned charts, graphs and plots. Each graphical display allows the information to be displayed in a different way such that relationships and changes to the variables over time can be observed. A few of the benefits of these excel tools are the following:

• Improves presentation
• Aids analysis of information
• Helps financial decision making
• Communicates financial ideas

Descriptive statistics

Summary statistics take numerical data and reconfigure it into analytical metrics. For example, if one has a list of weekly customer counts for an annual or 52 week time period, that data can be summarized using a number of excel tools. For example the weekly client count can be organized by rank from highest to lowest or lowest to highest. Some of the descriptive statistics made possible through Microsoft excel include the following:

• Moving average: Changes in the mean over time
• Standard error or t-test: Summary of standard deviation using square root
• Standard deviation: Used to determine range of movement of variables
• Skewness: A non-normal distribution of data after being plotted
• Range: The low and high ends of a data distribution
• Mean, median and mode: average, middle and most frequent numbers
• Count: Total value of data

The above descriptive statistics can assist in determining potential future client counts, averages, fluctuations over time and fluctuation levels. While alone descriptive statistics might not be as useful in making financial decisions as with the aid of other excel tools, they do summarize data in a form that can be analyzed more easily.

Microsoft excels data analysis tools can be applied to financial data of many types. For example, product sales, costs and expenses, price movements, taxes etc. can all be measured, plotted and analyzed using excels analysis tools. What's more, the financial data of more than one business can be compared for assistance in determining market conditions and other in house vs competitor financial data.

In summary, Microsoft excel organizes, analyzes and calculates using financial data using the software's built in metrics and features. These tools can benefit a business in a number of ways. For example, the resulting statistics may assist a business manager determine how to adjust a budget, or which clients to spend more money advertising to. Also, the financial analysis may demonstrate how much a companies worth changes over time thereby informing the manager and/or owner as to whether valuation is to volatile or stable for the business climate.

Excel also analyzes data using pictorial displays that can assist a financial analyst determine percentage distributions, proportions and relations between financial products and variables, changes in financial data over time, accuracy of the software analysis outputs and possible causes for changes in data values. In other words, Microsoft excel organizes, present and analyzes financial data in such a way that further analysis, insight may be gleaned, and decision may be made from the resulting analysis.

Source:
1. Albright, Winston and Zappe. 'Data Analysis and Decision Making with Microsoft Excel' Albany, NY. Duxberry Press.

Understanding Net Operating Income

Net operating income (NOI) also referred to as Earnings before interest and taxes (EBIT) is the total gain from sales after a business or corporation's operating expenses have been deducted. Sometimes these deductions lead to a net operating loss. 

Net operating income is different from 1) income after interest and taxes, 2) net income and 3) net income available to shareholders because it is income after expenses and not income after interest and taxes. What's more deductions to net income after interest and taxes may also reduce retained earnings and lower profitability calculations such as price to earnings (P/E).

Attributes of net operating income

The net operating income is one of several financial values that assist in clarifying financial positioning. The value is particularly useful in assessing debt management and profitability of a company. A few of the attributes of net operating income include the following:

• Is found in the income statement of company financial records
• Assists financial analysts, managers and shareholders in determining cost efficiency
• Categorizes expenses by item ex. Administrative, research, and marketing expenses
• Can be inputted into ratio analysis ex. Times interest earned (TIE) and Basic earning power (BEP)
• Is also listed in quarterly financial reports and Government tax filings
• Helpful in determining business valuation

How to calculate net operating income and related calculations

Net operating income is a simply calculation and is found by subtracting expenses before interest on debt and taxes on income from revenue which is the same as monetary proceeds from sales. To utilize net operating income (or loss) to gage debt management and profitability the following two ratios can be used. (Brigham & Houston p.107)

• Times Interest Earned (TIE): Earnings before interest and taxes (Net operating income)/Interest charges

• Basic earning power (BEP): Earnings before interest and taxes (Net operating income)/Total assets.

The higher the TIE ratio the better as this indicates a greater amount of operating income in comparison to interest expense on debt. Similarly, the higher the BEP ratio result the better as this indicates a higher operating income return per asset worth.

Net operating income can also be applied to valuation of property (www.realdata.com). Specifically, when divided by capitalization rate i.e. expected return on investor capital, the resulting value can be used as a form of property valuation based on income generated by that property in the form of pre-tax and interest income.

Advantages and disadvantages of net operating income

While the net operating income calculation generally has more advantages than disadvantages, there are a few factors to take into account when reviewing this figure. Specifically, as with all financial statements, the recorded values are from a moment in time and are only a reflection of financial transactions used in the income statement. In other words, a dramatic drop in revenue, client base, economic circumstances, operating costs etc that occur as soon as a day after the issuing of the income statement will not be reflected in that statement's net operating income.

Additionally, since net operating income does not include interest on debt and taxes the numerical value may be misleading if not also understood in the context of net income and net income available to shareholders which are the "bottom lines" of the income statement.

The net operating income is nevertheless a useful and vital financial value that should not be undervalued in terms of financial analysis. It's use in ratios and the income statement is continued in accounting practice for good reason because it does indicate profit margin before interest and taxes and when compared to revenue figures is a good gauge of cost control.

Summary

Net operating income is a financial value found in business and corporate financial statements most notably the income statement. This value is found after operating expenses such as overhead, employee, advertising etc. and before taxes to income and interest on debt are deducted. 

The net operating income is used in financial analysis, reporting, valuation and assessment and is both useful and potentially misleading if not considered in terms of broader financial context, corporate environment conditions and time of reporting. The NOI value is thus a useful but incomplete representation of business income and beneficial in determining financial relationships between operating costs and sales figures.

Sources:

1. http://www.realdata.com/ls/noi.shtml
2. Eugene F. Brigham, and Joel F. Houston. Fundamentals of Financial Management 9th Ed. South-Western, 1999.p277-281.
3. Howard Bryan Bonham CPA, The complete Investment and Finance Dictionary. Avon Media Corporation, 2001.p.62

How Finance Pros Read Company Reports To Assess Investments

Financial professionals will read company reports to assess investments in the interest of their organization, function, and objective(s). Some of the financial information reported by a company may include investment data, company objectives, project goals, expansion capacity, and return on investment among other things discussed in this article. Each financial professional will likely look at corporate reports in a way that is framed by his or her financial goals and objectives. For example, A Chief Financial Officer (CFO) seeking to increase short term return on assets may view a company report in terms of asset turnover. A list of the types of financial professionals who use company reports is below and implies the multiple purposes and uses of company reports.

• Fund managers and actuaries
• Chief Financial Officers (CFO's)
• Securities regulators
• Tax officials, auditors and accountants
• Investors, and venture capitalists
• Financial advisers and financial analysts

Types of company reports

Types of company reports can vary, each indicating different financial information. Some company reports include specific financial information relating to a single financial event whereas others will provide an overview of many financial events. Below are just a few of the corporate financial reports and/or company filings that may be used by financial professionals for a number of reasons.

• Notice of Sale of Securities
• Annual and quarterly reports
• Notice of Exempt offering of Securities
• Financial statements ex statement of cash flow
• Statement(s) of acquisition

The report itself and the objective of the financial professional will often determine how the report is read. For example, a securities regulator may look at a sale of securities filing to confirm the buyer of securities. In such case the documentation verifies information so as to avoid fraud, protect the seller of the securities and compliance with securities law. An analyst may view the same report(s) with different eyes though. For example, if a company has reported securities as sold how does that affect the business in question. Some reports are easier to read than others and how they are read can take on an information gathering purpose.

Quantitative data within company reports

Quantitative data within a company report is essential for assessing numerous pieces of information such as if a company is profitable and how much the profit margin among other things has changed. Depending on the financial professional, company reports may be analyzed heavily or used for key data such as sales, earnings, debt, industry developments etc.

Company financial ratios are also used with information from company reports. In the banking industry ratios are sometimes included in company reports. Ratios measure things like how well the business retains staff, how much debt the company has, how quickly inventory turns over and how much financial leverage there is in a business. Financial ratios are like the vital signs of a corporation and should often meet certain quantitative criteria to be deemed useful to a financial professional.

Statistical analysis is another area of quantitative analysis that can be used for assessing probability, correlation, validity in financial relationships, trends, patterns, distribution and more. Statistics are important in narrowing down estimates for accuracy. Although statistical results are not absolute they can provide extra verifications to analysts and researchers findings which can also be recorded in company reports.

Qualitative data within a company report

Qualitative data is that information within a report that has indirect influence on financial numbers. For example, how a company may be impacted by a new legislation enabling production and trade of a particular product, or approval of a patent by a Government agency, or a marked decline in the number of businesses in an industry may all be considered qualitative developments written in a company report. Qualitative data is also used to assess market conditions and may accompany executive meetings in addition to company reports.

Qualitative data exists when numerical data doesn't. Since business performance is not always numerically determined, qualitative assessment of business operations, market environment, regulatory environment, economic conditions and competition may all be included in an annual report or presentation if considered relevant by the company executives. Qualitative data is sometimes less defined, and more open to interpretation, but can also contain highly useful insights into a business.

Terminology and conditions

Another part of a company report is the legal terminology that may include disclaimers, liability waivers, legal requirements, violations, contractual obligations, legal settlements, lawsuits, judgments and/or rulings. Depending on the type of business this part of a company report may be extensive or brief. A fund manager may look for pending law suit rulings, new law suits, bankruptcy filings, mergers and acquisitions and other legal events that can affect the company. In any case, legal events may be significant part of a businesses activity which may or may not be a good thing depending on the type of event and the type of business.

Valuation Methods: Discounting Cash Flows vs. Using Multiples

Discounted cash flow (DCF) is the present value of an estimated future flow of money into a business, financial instrument or project. Multiples refer to ratio multipliers where the results of financial ratios are multiplied and then compared to the same multiplier for competing businesses. 

Both discounted cash flow and multiples are valuation tools, where the former technique weighs present value of future cash flow against an asking price, and the latter compares operational aspects of business performance. This article will discuss advantages and disadvantage to each valuation method in addition to illustrating how each is calculated.

Advantages and disadvantages of discounted cash flows 

The discounted cash flow equation allows one to estimate how much a future stream of payments are worth at present value. This can be useful in determining bond, and annuity values given an assumed future cash flow of specified amounts. In other words, the discounted cash flow is a mathematical method to determine actual rather than estimated present value of cash flow. In the case of large transactions or financial agreements involving considerable and predictable payment streams, this calculation can be invaluable.

A problem with the discounted cash flow equation is that the equation does not take into account several other factors such as 1) investment risk associated with opportunity cost. 2) unforeseen variations in future cash flow and 3) In other words, investments that could return greater cash flow yields would add an unrealized element of risk to the DCF. Additionally, economic factors such as interest rates and inflation are not incorporated into the equation.

Multiples: Advantages and disadvantages

Multiples can be a good way to get a general sense of business performance across a range of metrics such as asset and debt management, liquidity, profitability etc. If the ratios perform lower than industry averages or competitors, the company may not be a good strategic investment, acquisition or franchise opportunity depending on the circumstances surrounding the calculation.

With multiples, ratios are compared between similar companies. For example, company A produces serrated metal pipes for pluming and has a market capitalization of $250 million making it a small cap. Company B also manufacturers serrated metal pipes but is vertically integrated meaning it also distributes and installs the pipes. This element alone makes the ratio multiple somewhat invalid in the sense it is not an exact comparison.

How to calculate discounted cash flows and multiples

• Discounted cash flow: Financial calculator method

A simple way to calculate discounted cash flow is using a financial calculator. Using a financial calculator allows the step of incorporating mathematical steps to be bypassed and in the case of a present value of an annuity only three variable inputs are required 1) interest rate 2) time as expressed by a number integer and 3) cash flow as either a single or multiple set of payments at either the same or different amounts. 

To do this all one need do is input number of payments by pressing (N) on the calculator followed by the number, then interest, by pressing (I) then interest, then (PMT) for payments with a negative payment amount and (FV) with 0 then computer (PV). This will yield the present value of a future flow of cash payments and assist in determining value of that cash flow. For varying cash flows, the series of uneven cash flows will have to be entered into the calculator using the (CF) cash flow function.

• Discounted cash flow: Mathematical method

There are several different methods for calculating discounted cash flow, each making use of different variables such future capital investments, weighted average costs, and cash flow streams. Determining which method(s) are most suitable for a valuation may require an additional understanding into the entity in question and is in and of itself an appraisal method decision. Calculating discounted cash flow manually involves calculating net present value (NPV). The following is one such method and makes use of the weighted average cost of capital (WACC).

Step 1: Calculate WACC: For each percentage portion of 100% of capital invested calculate the percentage interest then average. Incorporating For example, 45% of 100% of capital invested costs 6% annually whereas the other 55% costs 5%. 45% of 6%=2.7 and 55% of 5%=2.75%. 2.7%+2.75%=5.45% =WACC This is a simple method for calculating WACC that does not incorporate taxation and does not differ between types of investment capital, but rather percentage costs of investment.

A equation for incorporating tax costs into weighted average cost is as follows: (Debt)*(1-Tax rate percent)*(Percent cost or Interest on debt)+(Equity Investment capital)*(percent cost of equity investment) (www.wikepdia.com)

Step 2:

NPV=Cash flow(s)/1+r to the exponent of the numerical order of the cash flow payment, where r=WACC (www.investopedia.com) For example, for 3 cash flows of $100.00 the equation using weighted average percentage cost of capital would be as follows. $100.00/(1+5.45%)exp 1+ $100.00/(1+5.45)exp 2 + $100.00/(1+5.45)exp 3=$64.73+$41.89+$27.11=$133.73

In addition to the above 2 methods of calculating discounted cash flow, are other methods such as via statistical programs and online calculators. Instructions for these calculations can be found using software tutorials and/or online financial calculators.

Calculating multiples

Calculating multiples simply involves determining the result of financial ratios such as the price earnings (P/E) ratio or Days sales outstanding (DSO) and comparing them across an industry average. For example, if company A has a price per share of $25.00 and annual earnings per share of $1.25, the P/E ratio is 20. If the industry average has a P/E of 30, it means competing companies have higher expected earnings as reflected through share prices making company A's ratio multiple below industry average.

How to incorporate discounted cash flow and multiples in investment decisions:

To make the best investment decisions will always be an art or at best a quasi-scientific estimate due to the elements of risk, probability, varied market conditions, inflation, leveraging etc. For this reason, making use of equations and tools such as the discounted cash flow and multiples can be of quantitative assistance in determine more accurate estimates of worth and/or valuation of a potential investment.

To illustrate the above, Mr. Jones wants to buy an annuity through Company I, the annuity agreement involves a monthly payment of $500.00 for 10 years at interest rate of 5%, with annuity payments beginning on the 11th year for $625.00/month. Using the financial calculator method above, this amounts to a present value of just $9701.89 when the actual payments amount to $60,000.00. What's more reversing the scenario and calculating future value for the same payments at 5% interest the value becomes $176,791.854 after compounding interest. In other words, the annuity would have to pay back approximately 22.66 payments or more to meet the 10 year future value level.

In summary, the discounted cash flow calculation can be useful in numerically determining actual value of a future cash flow stream as opposed to estimated value. The discounted cash flow equation is thus more useful in determining present value of future cash flows rather than business operational factors as measured by multiples. The former DCF, may be more beneficial in the valuation of financial instruments such as bonds, and annuities than in business acquisitions and equity positions. Nevertheless, both equations can be used in valuation in both scenarios however each is more suited to particular financial conditions.

Online sources:

1. http://www.investopedia.com/terms/d/dcf.asp
2. http://www.investopedia.com/terms/m/multiplesapproach.asp
3. http://en.wikipedia.org/wiki/Weighted_average_cost_of_capital
4. http://en.wikipedia.org/wiki/Discounted_cash_flow

Text references:

1.Howard Bryan Bonham CPA, The complete Investment and Finance Dictionary. Avon Media Corporation, 2001.p.62
2.Eugene F. Brigham, and Joel F. Houston. Fundamentals of Financial Management 9th Ed. South-Western, 1999.p.107.
3.Howard Bryan Bonham CPA, The complete Investment and Finance Dictionary. Avon Media Corporation, 2001.p.62
4.Zvi Bodei, Alex Kane and Alan J.Marcus. 'Investments' Mcraw-Hill Irwin. New York, 2002. P. 265-271

Why Financial Data Isn't Always Accurate

Sometimes financial, and economic data don't seem to make sense, but in reality it does as most things happen for reasons, even if those reasons are no reason at all. In other words, just like the people, events and computers data represents, financial and economic data is a monetary reflection of a medley of fact, opinion, motive, and analysis.

To rely solely on authoritative data is like blindly worshiping a financial god that's measurements are often only angles of a statistical sample. Since no humans or computers are gods i.e. figuratively perfect, it follows that data emerging from such is subject to error, fallacy, manipulation or any number of influences. Statistical data supports this claim!

To illustrate with example, according to the U.S. Bureau of Labor Statistics there are six alternative measures of "labor utilization" including the 'official' unemployment rate. So what exactly does this mean sans le langage locales? It means that the BLS is officially acknowledging there are five other ways of looking at the same thing, but that only one way is endorsed as official data, and not that the other ways are wrong.

Another example of inaccurate financial data is historical in context. According to a publication by the Herald Tribute Media Group, Moodys, Standard & Poor's and Fitch all over rated mortgage backed securities that they were 1. Paid millions to rate the MBS' by Goldman Sachs, and 2. Were later acknowledged to contain bad loans by Goldman Sachs, the MBS packager. If that's not convincing enough, how about Bernie Madoff's client financial statements; they were on paper and on company letter head so had to be authentic right?

Some may contend, financial data is transparent, but what good is transparency if all you clearly see is false, partially false or occasionally true? Conflicting financial data might not even conflict until it's viewed in hindsight such as with the above examples. Even if financial data is accurate, which it is sometimes, it often only represents a fraction or variable in the total equation of what is really going on with a sector of the economy, financial market, business etc.

So what does work then? How can conflicting financial data be assessed accurately? That is the big question, that the answer to is probably priceless if it can be applied to any situation. For starters though, as with scientific verification, conditions must be repeated to be true of causal and/or correlated relationships. For example, and there are many, if two of four major companies in an oligopolistic industry report layoffs and a quarterly loss does this implicitly necessitate the industry is in decline or that the other two businesses are also experiencing financial challenges? Not always.

There are many ways to financially slice and dice the above scenario. For example, what stage in the business cycle are they in? did the CFO's report that revenue increased do justice to the increased cost of goods sold? Do the other companies have better technology, marketing and business development? Is their cost of capital too high?

There is simply often lots of data to analyze in any given financial scenario, and the more data there is, the greater the probability some will conflict as size yields complexity and hence, differentiation among attributable financial data. In such case accurately and efficiently compiling and interpreting financial data becomes important. Hence, the answer to the question, 'how can conflicting financial data be assessed' is, with effective data management.

Sources:

1. http://bit.ly/bhaiHm (D. Dremen: Forbes)
2. http://bit.ly/cStGam (Bureau of Labor Statistics)
3. http://bit.ly/cdUjyN (J. McCabe: Herald-Tribune Group)

Technical Analysis of Sensex using Oscillators and Elliott Wave Theory

SENSEX is a shortened term given to the 'Bombay Stock Exchange Sensitive 30 Index'. The index is a broad based, weighted average composition of the share price of 30 large capitalization companies within the exchange. This index is considered one of the Bombay Stock Exchange's key metrics of market performance and has been in existence since 1986.

Since exchange indexes measure performance of stock baskets, analyzing SENSEX using technical methods can assist with trading tactics and strategy. Two such technical measures are oscillators and the Elliot wave theory. The remainder of this article will discuss how these two methods of technical analysis can be applied to SENSEX.

Oscillator technical analysis

Simply put, oscillators measure buying and selling opportunities at the high and low ends of market pricing. Several oscillators exist including 1) the Stochastic Oscillator, 2) Percentage Price Oscillator and 3) the Money Flow Index (investopedia.com), however other commonly used and referred to oscillators also exist. Each oscillator indicates different values based on varying underlying conditions for which a security price may be more apt to move in a certain direction.

To illustrate the above point, the Money Flow Index (MFI) measures volume of capital moving into a security. When the MFI value moves higher, it means the increase in capital inflow is rising, however, if the value is too high, it means the capital inflow has been taking place for a while and a price trend reversal may occur.

Elliot Wave Theory analysis

The essential basics of Elliot Wave Theory is that it makes use of 1) stock price movement graphical 'waves' and 2) impulsive or corrective trend analysis of those waves. What this means is that when the zigzag pattern of stock price movements on a graph are illustrated, a pre-determined wave theory i.e. Elliot Wave Theory is applied to the patterns.

These patterns are simply two consecutive patterns of zig zag waves of 5 then 3 movements or 3 then 5 movements. Specifically, if the price trend moves downward with 1 down movement followed by an up then down movement, and is subsequently followed by the same pattern in the other direction, i.e. up, then the Elliot Wave principle applies. After the down or up sequence, the Elliot Wave Theory indicates the probability of the trend continuing as previously is higher than had the trend not existed.

Applying oscillator and Elliot Wave Theory to Sensex

The next step in applying both oscillators and the Elliot Wave Principle involves obtaining the price chart for the SENSEX for a given period of time. These charts can be obtained from financial websites and the Bombay Stock Exchange website itself. Once a chart and price history values are obtained, the oscillators for the preferred point of time can be calculated and the Elliot Wave patterns can be looked for. Some financial websites search for wave patterns and/or calculate oscillators for the investor, trader or analyst to save them time in identifying, calculating and applying the oscillator formulas and wave trends.

Should the need to calculate the oscillators arise, the individual oscillator formula should be acquired then utilized for the correct value. Similarly, for the Elliot Wave theory, the wave patterns should be manually looked for and identified individually rather than via a technical analysis software or financial website feature. Several financial websites and/or technical analysis websites exist that either provide or specialize in technical analysis tool and software.

1. http://www.stockta.com
2. http://www.stockcharts.com
3. http://www.investorprofit.com
4. http://finance.yahoo.com
5. http://www.google.com/finance

Summary

The SENSEX is a metric that indicates performance of companies within the Bombay Stock Exchange. This index is similar to the Dow Jones Industrial Average in the U.S. however is comprised of 30 large Indian corporations weighted in the index by their equity capitalization values.

In studying the SENSEX, both oscillators and the Elliot Wave Theory can be applied for the purpose of technical trend analysis. Both these indicators are used to forecast future price movements either up or down based on previous trends in securities pricing.

To apply oscillator tools and the Elliot Wave Theory to the SENSEX involves obtaining a time period for which price trends can be illustrated and searching for and/or calculating the oscillator values at the time of interest and/or the wave pattern positioning for the same.

If the oscillator value is above a certain point, it may be a downward trend could occur and if the Elliot Wave pattern sequence is evident, the possibility of the security's market price following this pattern either up or down is forecasted.

Neither oscillators or the Elliot Wave Theory are absolute indicators meaning there is room for error and the technical analysis is not 100 percent accurate. Rather, oscillators and waves can be used to estimate price trends and movements based on pre-derived mathematical and/or statistical relationships and patterns.

Sources:

1. http://www.bseindia.com/about/abindices/bse30.asp
2. http://www.bloomberg.com/apps/quote?ticker=SENSEX:IND
3. http://www.investopedia.com/terms/o/oscillator.asp
4. http://www.elliottwave.com/introduction/wave_theory.aspx

Finance Professionals Assess Hybrid Portfolio Theory (HPT)

Hybrid Portfolio Theory (HPT) is a model of financial management intended for use in client portfolio asset allocations and investment decision making by investment managers.

The term Hybrid Portfolio Theory (HPT) has multiple meanings ranging from diversified asset allocation with risk and reward optimization in mind to investment selection based on algorithms and quantified investment data. This article will outline and assess hybrid portfolio theory in terms of its meaning, benefits, disadvantages and validity.

What Hybrid-Portfolio Theory is

In simple terms, hybrid means the conversion of two financial methods; portfolio means the distribution of assets via investment and/or asset allocation, and theory means, a tested but not absolutely proven financial hypothesis. Thus, HPT is essentially an investment management optimization theory. Below are two examples of HPT, both of which are quite differentiated from one another.

1. Hybrid Portfolio Theory using algorithmic data compression:

The application of Hybrid Portfolio Theory ideally produces financial consistency and returns with higher returns on investment with less risk making it an investment selection model. An example of Hybrid Portfolio Theory is described by Paul Bao and Hakman Wong uses several key components including the following:

• Fuzzification: Data classification
• Compression techniques: Simplification of information
• Genetic algorithm: Analysis of changing data for use in a formula

Since 'fuzzification', 'data compression' and 'algorithms' can vary, so can a Hybrid Portfolio Theory. In other words, HPT can be viewed in terms of 1) data in, 2) data processed, and 3) data out. All three steps in the HPT model can vary making the actual data, its processing and outcome important to the validity of the model.

2. Hybrid portfolio using non-sequential data analysis:

This second model of Hybrid Portfolio Theory is more static and presumes conditions don't change, but rather follow general principles that are consistent enough to be incorporated into the theory. This particular version of Hybrid Portfolio Theory is attributed to Jeff Joseph of Prescient Advisors and makes use of a split portfolio technique. The two portfolios combine low risk and average return in the majority of the split portfolio and high return with optimized risk in the minority portion.

Essentially, this theory goes without saying, but does provide financial planners with a method by which to allocate assets. The question with this HPT is which particular investments provide the portfolio with its intended results, i.e. one can easily state the conditions by which an objective can be achieved without actually defining how those conditions can be met.

Benefits of Hybrid-Portfolio Theory

The benefits of Hybrid-Portfolio Theory are unique to the actual performance of the application of the theory. In other words, both the above theories must be demonstrated to work to be considered beneficial to an investor or investment manager. Until that is done, the HPT theory is just another theory that sounds interesting, but may not actually be any better than simpler quantitative techniques of investment analysis combined with intuitive insight, existing knowledge and traditional analysis.

The benefits of traditional analysis techniques such a technical analysis and fundamental analysis is that they are time tested to be accurate within a certain range. The goal of new models and theories such as Hybrid Portfolio Theory is to improve upon the accuracy of the predictive capacity of existing investment analytics, investment management models and financial planning policies.

Disadvantages of Hybrid-Portfolio Theory

The Hybrid Portfolio Theory put forth in the second example above is a reaction to what it refers to as "black swan" market conditions. In this reaction, the call for lower risk investment techniques is emphasized in order to reduce the probability of highly volatile asset value swings. Essentially the 'theory' states by aggressively reducing risk while simultaneously increasing return an investment portfolio can achieve an 'asymmetrical' return i.e. a ROI that is not symmetrical with risk.

The disadvantages of both the above techniques are 1) opportunity cost, 2) validity verification, 3) fiscal and temporal cost. In other words, the theory needs to be proven, and the theory needs to be proven as being better than other investments in terms of both risk and return. Additionally, especially in the case of the first HPT example, the quantitative and information technology consulting and upfront costs for such a model, especially in the case of asset managers, may be high, making the necessity of value for the premium to be worthwhile.

Validity of Hybrid-Portfolio Theory

"In theory", there's nothing invalid with the assertions made by either Jeff Joseph's, Paul Bao and Hakman Wong's HPT. However, financial models are not financial theories, and financial hypotheses are not financial models. On first impression, it seems as though HPT may encompass a little of all three of these terms of validity potentially giving it more credibility than might be justified.

As with any hypothesis, model or theory, until the data is demonstrated to be both statistically significant, and quantitatively proven, it is nothing more than financial idealism packaged within fiscal lingo. This is not to say Hybrid Portfolio Theory doesn't work, but it is to say, HPT must first be demonstrated to work, and the burden of proof is on the proponents of the theory.

Sources:
1. http://tinyurl.com/4tv62e2
2. http://tinyurl.com/4ftwbr2
3. http://tinyurl.com/lrxfgn
4. http://www.badros.com/greg/papers/badros-dcc94.pdf

The Use of Normal Distribution in Finance

A financial normal distribution is a statistical term used to describe how particular population sample characteristics or event(s) results are placed in relation to each other. The normal distribution is used to help predict and adjust for a wide range of financial goals by optimizing financial decision-making by applying and graphically mapping financial data into a distribution set of variables.

In other words, data such as prices can be plotted on a normal distribution graph with dots. The dots are then connected with a line that reveals the data's distribution in terms of two axis continuums known as the X and Y axis on a graph. An example of a normal distribution is the amount of money spent on obtaining the calories consumed by individuals over time. If the X axis represents calories consumed, and the Y axis represents cost per calorie, the data set will produce a statistical and graphical distribution when plotted on graph.

This article will illustrate how the normal distribution is used in finance in addition to providing tips and techniques for applying the normal distribution to financial practices such as investing. It is important to note the normal distribution is not the only type of statistical distribution, and thus the mathematical benefits arising from use of normal distributions in finance may not be realized for non-normally distributed data.

How normal distribution is used in finance

The normal distribution is used to make quantitative and qualitative financial decisions based on the mathematical nature of normal distributions. This is to say, normal distributions tend to follow certain similarities such as conglomeration of distribution toward the mean among other things such as standard deviation from the mean.

Due to this and other trends, numerical forecasting is more justified by the statistical patterns underlying the data. Thus, determining if certain financial events are normally distributed can be useful because those events may be more likely to follow probabilistic patterns in the future.

To illustrate further, the normal distribution helps financial analysts and/or investors make better financial decisions based on the statistical information provided by the normal distribution. Using the example above, if a sample of 20,000 people reveals that the average daily calorie consumption of Americans is 2100 calories per day, and the majority of food consumers are near this range, with others calorie levels tapering off evenly above and below this point, the distribution is normal.

This can then lead to a mathematical connection between calories consumed and dollars spent on calories. The data can be further analyzed if two normal distributions exist at different price levels all other variables such as population held constant.

If investors want to determine how caloric intake affects consumption trends at fast food chains, it is probable a maximum revenue for the chain can be assumed based on the normal distribution of the population samples caloric intake. Furthermore, if price per calorie rises at the fast food chain, a new normal distribution may be formed creating what is known as correlation or the statistical measurement of a change in one set of variables influencing another set of variables.

For example, if the price of burgers at a burger food chain rise by 20% and the caloric intake of the population declines but is still normally distributed, a correlation may be present. The degree of these correlations can be used to determine if price rises may be profitable and therefore a good or bad investment. A few more ways normal distributions can be used in finance are listed below.

• To determine probability of financial events occurring 

• Can be used in comparing financial events and/or products 

• Statistically assists in assessing risk 

• Helps in forecasting return on investment (ROI) 

• Presents data in an easier to understand format 

• Allows an investor to measure statistical accuracy 

Tips and techniques for applying normal distributions

When using normal distributions to make financial decisions, there are techniques and rules that can be utilized to make the abstract nature of statistics more down to earth and 'realistic' in terms of common financial concerns such as profit, cost, accuracy of information, competitiveness etc. A few of these rules and principles are listed below and may convey a more helpful way to make sense of and apply normal distributions in finance.

• Determine the line of best fit: When multiple data sets are obtained from the same sample group over time, an average distribution can be obtained. This is known as the line of best fit, which if a group of normal distributions without a change in variables, has the effect of averaging the normal distribution. Thus, a normal distribution that is averaged in this way may be more accurate.

• Find the Beta value: The beta value is the correlation i.e. relationship between a depending variable such as a company stock price with an independent variable such as industry raw materials costs. If the beta value is above 1, the correlation of movements in prices between the two variables is higher.

• Look at the P-Value: When comparing two hypotheses represented by normal distributions the P-value illustrates the quality and strength of the statistical analysis. Small P-values under .05 or lower are good.

• Use computer software: A good statistical software program will make the tough statistical calculations easy with a sound understanding of the statistical principles and their application in finance. This saves time and energy on calculations.

• Make sure the distributions are relevant: Normal distributions may not be financially helpful if they don't have a strong bearing and implication on a financial decision being made. For this reason, making sure the information is relevant can help optimize decision-making.

• Plot the distribution on a graph: Graphical illustrations of statistical data can help make it more understandable and complement statistical values and probabilities.

Summary

Normal distributions help determine financial trends and relationships. These trends and relationships can then be used for comparing financial products, forecasting financial outcomes, assessing risk, and predicting return on investment, estimating cost and demand among other things.

Certain statistical data may be more useful than other statistical data so it is important to know what to look for when applying the statistical values of normal distributions to financial evaluations and choices. Also, since not all distributions are normal, it is important to determine whether or not a distribution is in fact normal, for the mathematical characteristics of normal distributions to apply. When utilizing normal distributions correctly applying the data derived from the distribution to the financial application is key.

Sources:

1. http://tinyurl.com/4s77kpt
2. http://www.investopedia.com/terms/n/normaldistribution.asp
3. http://www.investorwords.com/3344/normal_distribution.html
4. http://www.childrensmercy.org/stats/definitions/pvalue.htm
5. http://www.netmba.com/statistics/distribution/normal/

Using Capital Turnover Ratio to Analyze a Company's Financial Statements

The capital turnover ratio, also defined as the working capital turnover ratio, measures how effective a company's use of debt is. The ratio is calculated by dividing sales revenue for a specific period of time by the difference between short-term assets and short-term liabilities for the same time period. (www.investopedia.com) The reason why liquid assets and liabilities are used is they are more reflective of capital cash flow for operations than long-term assets. The capital return ratio can be utilized in appraisal of a number of financial scenarios.

• Business valuation and profitability measurement
• Assessment of business performance
• Determination of variation in profitability over time
• Profitability in relation to market and/or operational returns
• Evaluation of acquisition risk

Using the capital turnover ratio to analyze a company's financial statement will assist in discovering return on debt. The higher the ratio, the greater the revenue return per dollar of debt is as measured by the ratio. Since time is a factor, the capital turnover ratio can change on a quarterly and annual basis.

For this reason, it may be more effective to measure the capital turnover ratio for different periods. If the differences in the ratio value are volatile, it indicates either fluctuating sales and/or variable debt. That is to say, if the ratio changes significantly over different time periods of measurement, sales and/or debt use may be unsteady and therefore the company may be a greater investment risk.

To illustrate how the capital turnover ratio is used, the following example can be used. Company X has a first quarter revenue of $500,000.00, its liquid assets for that same quarter are valued at $400,000.00 and liquid liabilities are $200,000.00. The difference between the assets and the liabilities are $200,000.00 making the ratio calculation $500,000.00/$200,000.00= 2.5. For the second fiscal quarter, sales decrease to $400,000.00, short-term assets increase to $450,000.00 and short-term liabilities increase to $250,000.00. The second quarter capital turnover ratio will consequently change to $450,000.00/$200.000=2.25.

The capital turnover ratio can be calculated over time to arrive at multiple indicators of return on capital including 1) an average capital turnover ratio 2) variable capital turnover ratios and 3) Correlated capital turnover ratio. The average capital turnover ratio will yield a ratio value that represents the capital return over a larger period of time whereas the variable capital turnover ratios can assist in determining seasonal, cyclical and environmental shifts in capital returns.

Furthermore, if the individual capital return ratios are correlated against a market index such as the Nasdaq, several other numerical relationships can be discovered. For example, quarterly percentage differences in the capital return ratio can be divided by quarterly percentage differences in the Nasdaq to determine if fluctuations in the ratio are statistically linked to variations in market returns over the same time period.

Additionally, the variable capital turnover ratio can be measured against internal performance benchmarks rather than against market returns as in the company to market beta relationship. That is to say, rather than relating the variable capital return ratios to a market index they can be related to other internal ratios such as profit margin on sales, return on equity (ROA) or return on assets (ROA).

To do this calculate the percentage change or average percentage change in the capital turnover ratio by dividing each periods capital turnover ratio by the previous periods ratio and then continuing on and averaging those percentage returns for an average variable capital return ratio percentage. Then, divide that value by the average percentage change of any one of several profitability ratios such as profit margin on sales, which is net income available to shareholders divided by sales. (Brigham and Houston p.107)

The result will be a numerical value reflecting the average variable capital return ratio as a function of profitability rather than market returns. In this case, the closer the value is to 1, the greater the connection between corporate operations and profitability to debt management.

In summary, the capital return ratio is a measure of profitability. The ratio can be expanded through multiple calculations over time to determine variation in profitability and average profitability. Additionally, the capital return ratio can be used in risk calculations by measuring it against market returns and operational performance by inserting the percentage change of the ratio in to a beta slope calculation where the numerator value is the capital turnover ratio percent change and the denominator is the operational percent change as measured by profit margin on sales.

A company that makes good use of debt leveraging is more likely to have a higher capital return ratio than a highly leveraged company with the same sales. For this reason, the capital return ratio us useful for business valuation purposes, assessment of business performance, and calculation of relationship(s) between profitability and market and/or operational performance.

Sources:
1. http://www.investopedia.com/terms/w/workingcapitalturnover.asp
2. http://www.investopedia.com/terms/a/alpha.asp
3. Eugene F. Brigham, and Joel F. Houston. Fundamentals of Financial Management 9th Ed. South-Western, 1999.p.107.
 

The Difference Between Duration and Maturity in Bond

Bonds are specific types of loans to Government(s) be they foreign, federal or municipal, or Corporations. The interest for these loans can either be fixed i.e. unchanging or floating (changing) and is paid on specific time intervals. Bonds can also be convertible to other financial instruments, have the face value paid along with interest or not, and are exchanged in secondary markets such as the Chicago Board of Trade. Two important features of bonds are their maturity dates and duration. This article will discuss the difference between bond maturity and duration.

Bond maturity

Bond maturity is fairly simple to understand in comparison to duration. Since bonds are like loans, at some point the principle of the loan has to be paid back. For example, if a bond had a 30 year life in which "coupons" i.e. the interest rate on the face value of the loan were paid, the face value of that bond could either be paid along with the coupons or bought back early as in the case with "call bonds". However, other bonds do not pay back the face value until the end of the established term of the loan. This end of bond life is known as "maturity" and is the point by which the face value of the bond must be paid back.

Bond duration

Duration is an important financial equation that measures risk of return due to fluctuations in market interest rates. For example, since bonds are loans made from companies or governments to individuals or other companies or governments and new bonds are issued frequently, the benefits of older bonds may rise or decline in relation to new bonds. In other words, if interest rates rise on new bonds, the old bonds won't be as valuable in secondary exchanges because the new bonds are a better deal. The risk of this happening is termed interest rate risk and is measurable by the duration equation.

Duration is a very useful equation to investors because of its ability to quantify interest rate risk. This quantification assists in the investment decision making process and does so by expressing the relation between interest, time, and price variables of the bond. The result becomes an "interest rate sensitivity" i.e. risk level. Logically speaking, duration is a time value that either equals, is lower or greater than the original interest payments. In other words, when interest rates fluctuate old bond prices change, causing the duration value to also change. Since duration is a weighted average function of time, the greater the difference between original duration and new duration, the more risk is present in the bond.

Bond duration equation

The duration equation is a sophisticated combination of variables that each have a unique meaning unto themselves. However, one might consider the most important aspect of the duration equation to be the outcome rather than how it is calculated as it is the outcome that helps indicate investment risk. Nevertheless, understanding the logic and the relationships between the bond variables can help clarify the dynamics and depth of understanding between the variables. This can in turn, give one a greater appreciation for the nature of the bond market, and investments within it. A few key variables in bond duration are the following:

Important variables:

• Present value of payments: Value of interest payments in proportion to face value, bond price in secondary markets. Also known as discount rate.
• Bond price: Current bond price for used bonds
• Interest rate: i.e. coupon rate
• Face value of bond: The future value at maturity
• Future value of bond: The future value if other than face value
• Time i.e. number of interest remaining in the life of the bond

Duration can be calculated by adding the sum of the present value of coupons by the weight of that coupon in proportion to total payments including face value. There are a lot of concepts built into that last sentence. Of particular relevance is weighted average which is present value of coupon rates i.e. (adjusted interest payments based on current bond prices) divided by the latest bond pricing.

Essentially, in this case, weighted average is a concept within a concept that contains another concept i.e. present value which is calculated by inputting remaining payments, new interest rate, payment amounts and future value i.e. final bond payment into a financial calculator, spreadsheet application or by hand. The result becomes a time value that is either lower, higher or the same as the original bond duration i..e time between payments and term of the bond. If the duration is lower the risk is also thought lower and if the duration is higher than original bond duration, the risk is thought higher.

Summary

Calculating duration is a way to double check accuracy in bond pricing as well as determines price risk. For the most part, adjustments in bond prices are efficiently adjusted for in the secondary bond markets through market efficiency. However, some bonds may be at greater risk to opportunity cost i.e. the risk of obtaining higher yields from alternative investments. This being the case the duration equation is a necessary tool to bond traders and investors.

Since the duration equation can be complicated and conceptually advanced, it can be a good idea to break it down in terms of its sub-components and relationships. This can help make the final equation make more sense. Following this underlying understanding, the duration equation can be simplified and expedited through the use of financial calculators and spreadsheets.

Sources:

1. Bodie, Kane and Marcus. 'Investments 5th ed.' Boston. McGraw-Hill Irwin, 2002. p.485-492
2. Brigham and Erhardt 'Financial Management: Theory and Practice 10th ed' Mason, Ohio SouthWestern, 2002 p.352-357
3. http://en.wikipedia.org/wiki/Bond_duration
4. http://www.investopedia.com/university/advancedbond/advancedbond5.asp