Math 201: Three Financial Equations for Investing

By Mark Morelli - November 26, 2012 | Tickers: AMZN, AAPL, MSFT, VRTS | 0 Comments

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I'm in the process of reading the book "The 7 Most Important Equations For Your Retirement," by Moshe A. Milevsky. As indicated by the title, the author describes mathematical formulas that should be understood by those planning for their golden years. 

I thought I'd write about three financial equations that every investor should be aware of. I've already written about simple concepts like P/E ratio and dividend yields, so in this article I'll go slightly deeper.

Value and Growth: PEG

Two very important considerations for any investment are value and growth potential. There are many ways to determine a company's value, including brand, barriers to entry into an industry, and human capital. Growth can be estimated or projected based upon any number of methods. One way is to determine if a company can expand to other geographical areas.

One numerical indication of value also factors in growth. Price/Earnings/Growth (PEG) is calculated by dividing the P/E ratio by the projected annual earnings per share (EPS) growth rate. P/E ratio is the stock price divided by EPS. A lower PEG (and below one) usually indicates better valuation. Theoretically zero is the best PEG to have and infinity is the worst.

There are some caveats for using the PEG ratio. It is a calculation that is based upon predictions that could be inaccurate. It is a good idea to use the consensus of several estimates (or use the numbers provided by the company). It is best applied to stocks that do not pay a dividend or have a relatively low yield, and is useful for comparing companies across different industries (e.g. energy and tech). It may not be the best gauge of value and growth for every company (see below).

I'll provide some examples of the PEG calculation.

In October 2010 Apple (NASDAQ: AAPL) announced its 4th quarter results for that year. It reported 12-month trailing EPS of $15.15. The share price at that time was $309. The consensus estimate for earnings growth over the next 5 years was about 60% per year. Apple was actually projecting slightly lower growth. 

At that time I calculated a P/E ratio of 20.43 (309 divided by 15.15) and a PEG of 0.34 (20.43 divided by 60). The P/E was slightly below the 5-year average and its peers, and since the PEG was below 1 the company seemed to be a good value. The stock has since gained 82%. EPS actually averaged a gain of 71% a year between 2010 and 2012, beating both the company and analyst estimates so far.

Currently the numbers for Apple are a P/E of 12.8 and a PEG of 0.58 using a estimated growth rate of 22% per year. The stock still looks like a good value.

At the end of 1999, right before the Internet bubble burst, the software giant Microsoft (NASDAQ: MSFT) was flying high along with the rest of the tech companies. However, the stock had a P/E ratio of about 80 ($57 divided by $0.71) and a PEG of 3.5. In my opinion the numbers indicated that the stock might be overvalued. Starting in early 2000 investors sold off the shares. The company's market cap fell 50% by late 2004. 

Today Microsoft has a P/E of 14.6 and a PEG of 1.8. Much more reasonable in my book. 

Online retailer Amazon.com (NASDAQ: AMZN) presently has a P/E over 3,400 (yes 3,400) and a PEG of 89. It recently announced lower guidance and for the first time ever experienced an operating loss. It might not be considered a value stock. However, based upon its wide moat and other factors the stock may still be a good investment. The price has so far shrugged off the apparently high valuation. It is up 26% in the last 12 months, but recently is off its 52-week high. 

Virtus Investment Partners (NASDAQ: VRTS), a financial services company headquartered in Hartford, CT, appears to be a great value right now with a P/E of around 5.7, projected earnings growth of about 28%, and a PEG of 0.002 (5.7 divided by 28%). 

Management Effectiveness: ROIC

Another characteristic to look at is management effectiveness. There are many qualitative measures of good leadership such as whether or not the founder is still in charge of the company (if he or she is that is a positive) and what the compensation plan is (long-term incentives are good).

One quantitative measurement is return on invested capital (ROIC), which provides an indication of how efficiently the company uses capital to generate profits. Usually the bigger the number the better.

The calculation is ROIC (Net Income - Dividends) divided by Total Capital. Total capital includes long-term debt, and the value of the shares. Therefore, if there is little or no debt and lots of income that will maximum the ROIC number. Some companies prefer to return value through dividends and share buybacks instead of using capital so ROIC may not provide the whole picture. 

Apple currently has an ROIC of 41%. It peaked at about 48% earlier this year, but it has generally increased over time. 

Microsoft's ROIC is about 20% and has been declining over the last 4 years. It actually had a higher return than Apple until about a year ago.

Today Amazon has an ROIC of zero (net income is down) after peaking in 2008. Virtus has an ROIC of 61%. The company is generating lots of income.

Profitability: Gross Margin

One of the measures of profitability is called gross profit margin, or gross margin. The relatively simple calculation is total profit divided by revenue. If a company generated $100 million in sales and made $25 million, then the gross margin is $25 million divided by $100 million or 25%. A higher number is better.

Apple had a gross margin of 44% for the trailing 12 months, and analysts predict that it will decline over the next year. The gross margin for Microsoft is 75%, and for Amazon it is 23%. All good numbers. A gross margin could not be calculated for Virtus yet. 

Summarizing the calculations for the four companies:

So that is it for today's lesson. I provided three equations that can be used to analyze a company. Look for Math 301 in the near future.

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