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Measuring Financial Health: Asset Usage, Competitiveness & EPS

Instructor: Andrew White

Andrew has taught college and CFA level finance/investing. He holds a Bachelors in Finance (summa cum laude), Masters in Economics and the CFA designation.

To evaluate a firm, analysis of a corporation's asset use, efficiency, industry competitiveness, and valuation measures are key. These measures represent the intersection of corporate finance and investment management.

Financial Evaluation of Corporations

Is Amazon.com stock attractive? The firm is in competition with most all retail consumer goods/services providers, online and off. Domestically though, only WalMart and a few others come close to matching the business strategy and size of Amazon.com. Using measures of asset use efficiency, industry competitiveness, and common stock valuation will help determine if this a good stock investment.

Asset Use Efficiency

A good measure of asset use efficiency is the inventory turnover ratio, which is:

  • Sales (income statement) / Inventories (balance sheet)

The larger the figure, the more effective a firm's management of its assets to yield an earnings return (i.e. smaller inventories). Amazon's 3rd quarter 2019 (abbreviated 3Q19) inventory turnover was 14x = $265 billion revenue / $19 billion inventories.

Another gauge of asset use that is perhaps the most widely used is earnings per share (EPS):

  • Reported EPS = Net Income / Common Stock Shares.

Of equal interest is fully diluted EPS, which is:

  • (Net Income - preferred stock dividends) / (Common Stock Shares + conversion of fully-vested stock options, warrants, and other common stock-convertible securities).

Amazon.com's 3Q19 EPS was $23 per share.

Alongside EPS, investors watch actual cash flow per share (CPS):

  • Cash flow = Net income + non-cash expenses (e.g. interest, tax, and depreciation) + net increase in non-cash working capital

Non-cash working capital might change in inventories and accounts payable. EPS and CPS magnitudes usually differ at any point in time. The differences are not necessarily that important, but note rather how the measures change over time.

Amazon.com's 3Q19 cash flow per share was $71/share.

Asset efficiency measures for four companies. Notice that Amazon ranks higher (better) in inventory turnover.
Asset Use Efficiency

Industry Competitiveness

Profitability is naturally quite important in measuring the financial health of a corporation. Return on assets (ROA) is a good indicator of profitability and is calculated as:

  • Net Income / Total Assets

ROA is the end-of-day measure of how well management has deployed the firm's assets to yield earnings on those same assets. Amazon.com's 3Q19 ROA was 6%, roughly equal to industry competition.

To calculate another measure of profitability, an investor first determines the firm's liquidity or debt burden. One measure of debt burden is:

  • Total debt / Total capital = All borrowed debts / (Total liabilities + Net worth = Total assets)

The higher the debt burden, the greater the risk of insolvency in hard times. Amazon.com's 3Q19 debt burden was 0.3, which is on the lower end of its competition's range.

Return on equity (ROE) is a better measure of profitability:

  • ROE = Net income / Shareholders' Equity

ROE measures profitability from the perspective of investors versus the return on assets from the corporate management's view. Thus, asset's debt financing matters. ROE is equal to or greater than ROA for all positive ROAs. Amazon.com's 3Q19 ROE was 23%, which is good especially considering its relatively low debt burden.

Industry competitiveness measures for four companies. Amazon has the highest profitability but a lower debt burden.
Industry Competition

Stock Valuation

In themselves, asset use efficiency and industry competitiveness measures provide a snapshot but do not give insight into how the market currently views such measures. The price of the common stock share is the missing link. For example, PE, which is Price / EPS ratio, compares market's current valuation of a company to the firm's earnings. Amazon.com's 3Q19 PE was 78x. That's very expensive.

To finance a firm's asset and earnings growth, a business retains a portion of its net income for reinvestment. The measure of retention is the dividend payout ratio:

  • Dividends Paid / Net Income

The lower the dividend payout ratio, the more earnings are kept in-house for growth and not paid out to investors. Amazon.com's 3Q19 dividend payout ratio was 0, that is, it had 100% earnings retention.

Another measure of valuation is current dividend yield:

  • Dividends / Common Stock Share Price

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