Cap Rate = Net Operating Income / Price

Investors often use a derivation of the exact same income approach formula used by appraisers, but instead they solve for the cap rate.

Another way to look at the cap rate is that it represents the annual rate at which the property or investment pays for itself.

Using the income approach, an appraiser solves the previous formula to determine the value of a property.  To solve for the value, the appraiser needs an appropriate capitalization rate.

The capitalization rate or “cap rate” used by an appraiser is constructed from a mortgage constant and an equity rate of return.  The best way to obtain an accurate cap rate for your locale or type of property is to call an appraiser and ask for it.  You may also ask your banker what cap rates are being used in local appraisals.

You may calculate a cap rate yourself using the following method.  Start by determining typical percentages of equity investment and debt financing for similar investments.  The combined percentage of equity and debt must equal one hundred percent.  For example, you might assume twenty-five percent equity and seventy-five percent debt financing:

Cap Rate = 25% x Equity Rate of Return + 75% x Mortgage Constant

The “equity rate of return” represents an estimate of the required rate of return by investors in similar projects.  The mortgage constant simply represents total annual debt service divided by the loan amount.

Cap rates are usually calculated based upon prevailing market rates of return, interest rates, loan to value ratios, and mortgage amortizations for similar properties.  The specific numbers that appraisers plug into the cap rate formula are often determined by judgment calls.  Because of this, it is important to learn why appraisers use certain values and whether different appraisers in your area might make different assumptions.

Property Value = Net Operating Income / Capitalization Rate

The “income approach” is the primary method used by real estate appraisers to value investment properties.  Although they consider cost and market comparables as well, appraisers typically give the most weight to the income approach when valuing commercial property.

If the appraiser believes that market rents differ from the actual rents of the property, then he or she may substitute them.  Similarly, if a property requires a great deal of maintenance that has been deferred or if capital improvements will be necessary in the future, then the NOI or the value may be adjusted downward by the appraiser to reflect the situation.

The statement of income that is used for real estate properties differs from that of conventional businesses.  A typical real estate income statement looks something like this:

Potential Gross Income (or PGI)
Plus: Other Income
Less: Vacancy and Bad Debt Expense
Equals: Effective Gross Income (or EGI)

Less: Operating Expenses
Equals: Net Operating Income (or NOI)

Less: Debt Service
Equals: Before-Tax Cash Flow

Less: Income Tax
Equals: After-Tax Cash Flow

Potential gross income represents a full year of rents assuming that the property involved is fully occupied.  Other income might include payments for parking, laundry facilities, or fees.

Operating expenses include property taxes, management fees, (and a replacement reserve when used for an appraisal).  Debt service includes both principal and interest payments.

Note that operating expenses exclude depreciation.  In fact, deprecation does not appear anywhere within this form of income statement.  (Depreciation expense is, however, considered when calculating the income tax requirement.)  Because this type of statement excludes depreciation and includes principal payments, the bottom line represents cash flow as opposed to “net income”.

Return on Capital =       Net Operating Profit – Income Tax
                                       Total Long-Term Debt + Equity Capital

The Return on Capital Ratio is also known as “Return on Invested Capital” (or ROIC), and it measures a company’s efficiency at turning its total capital into profits.

This CFO article argues that ROC better measures company value than other efficiency ratios such as ROE.

PEG Ratio =                   P/E Ratio
                         Expected Annual EPS growth

We have already learned that when companies are expected to grow rapidly in the future, they generally exhibit high P/E multiples.  Investors are willing to pay more for a stock now if they expect to profit from increasing earnings in the future.  The anticipated earnings growth justifies the higher stock price relative to current earnings.

In order to compare apples to apples regarding companies with different growth models, the PEG Ratio was created.  This ratio attempts to even the score by dividing company P/E Ratios by their expected growth rates.

A problem with this ratio involves the fact that the growth rate is a prediction; it’s not a hard number.  The problem may be compounded when using “forward” earnings to construct the P/E Ratio.  In this case, two variables in the PEG equation are actually estimates.  A low PEG Ratio may result when the outlook for a company is too rosy, providing the misleading implication that the stock is underpriced.

For some reason, human beings tend to be relatively short-sighted when it comes to investing in stocks.  Instead of making long-term investment decisions, people often focus on relatively minor or short-term occurrences or temporary changes in earnings.  One result of this phenomenon is the fact that the traditional P/E ratio, which uses only one year of earnings in its calculation, is a very popular measure used in stock buy and sell decisions.  Many investors react aggressively to changes in a single quarter or a year of earnings or in anticipation of future earnings.

In his popular book, Irrational Exuberance, Robert J. Shiller instead recommends using an inflation-adjusted P/E covering the past ten years to support decisions about whether to buy or sell stocks.  This ratio is referred to as the P/E 10.

Since, the P/E Ratio can also be measured for a bundle of stocks, Shiller illustrates his point using the S&P 500.  During the times preceding a market crash, the S&P 500 has become overvalued, exhibiting a very high P/E 10.  The P/E 10 rose all the way to the low forties in 1999 and 2000 just before the tech bubble, and it reached high twenties again just prior to our current economic turmoil.

Shiller keeps an updated and ongoing spreadsheet of the P/E 10 calculation for the S&P 500 all the way back to 1871 here.

    P/E Ratio =     Stock Price
                          Earnings per Share

The P/E Ratio represents the multiple of a stock’s price over its earnings per share.  A stock with a high P/E (of around twenty or above) usually has high expected earnings growth as well.  The future earnings expectations are necessary to justify the high price relative to current or historical earnings.

A lower P/E (for example, a number closer to ten) may indicate that a stock is a bargain; although, it may also indicate some serious problem that is keeping the stock price down.

If earnings are particularly high or low due to some passing or one-time event, then the P/E may be thrown off or need adjustment.  If the stock price remains about the same, then you may attempt to adjust the financial effect of the unusual event out of EPS.  You can then use the adjusted EPS to calculate a more meaningful P/E.

Other times, the stock price will actually adjust to an anomalous change in earnings per share.  When this happens, the stock may become a relative bargain or become overly expensive.

EPS and P/E are widely used measures of stock performance and value.  The fact that an individual event or a single year of earnings may so drastically alter these ratios (and therefore the stock price) can be problematic.  It does not necessarily make sense to base the price of a stock on just one year of earnings.

Earnings per Share (EPS) = Net Income – Preferred Dividends
                                                         Average Outstanding Shares

Earnings per Share measure profitability on a per-share basis.  This earnings number is an important consideration when pricing a stock, and it is widely used in investment analysis.  It is also a component of the Price/Earnings multiple.

Keep in mind that one-time events such as asset sales and non-cash transactions such as depreciation may affect net income.  Because of this, the “earnings” figure in the numerator may not necessarily constitute an accurate portrayal of company operations or cash flow.

Earnings per share may improve (or become artificially inflated) when a company has recently purchased treasury stock or while earnings grow over time without the issuance of any new common stock.

Earnings per share may be “trailing” using the last twelve months of earnings or “forward” using projected earnings.

Return on Common Equity =        Net Income – Preferred Dividends
                                                     Common Shareholders’ Equity – Preferred Equity

Return on Common Equity is a variation of the return on equity (or ROE) ratio.  The formula is used to measure return for common shares of stock when a company has also issued preferred shares.  To adjust preferred shares out of the equation, preferred dividends are subtracted from net income and preferred equity is excluded from the calculation.

“Preferred stock” consists of shares of stock that have priority over common shares.  Preferred stock usually pays dividends, with preferred dividends required to be paid before common stock dividends.  Because of this, many financial ratios deduct preferred dividends when calculating returns and earnings that apply to common shareholders.

Preferred shareholders also have priority over common shareholders in the event of liquidation.  You may think of preferred stock as a hybrid of debt and equity.  Preferred stock has characteristics of both; although, it is presented within the equity section of the balance sheet.

Preferred dividends are usually fixed so that preferred shareholders receive no additional profits when things go well.  Preferred shareholders usually do not have voting rights either.

    Sales to Net Fixed Assets =   Net Revenue
                                                        Net Fixed Assets

The Sales to Net Fixed Assets ratio represents the productivity of property, plant, and equipment as measured by the level of revenues.  Note that heavily depreciated assets can distort any ratio involving net fixed assets.

    Sales to Working Capital =      Net Revenue
                                                       Net Working Capital

The Sales to Working Capital ratio measures the ability to generate sales based upon working capital.  Note that seasonal fluctuations in working capital (or a deficit value) may throw this ratio off.

Smith Heating and Cooling, Inc. generates $2.64 in sales for every dollar of net fixed assets.  To provide context, an analyst would compare this number to previous years and to industry figures.

The company generates $29.50 in sales per dollar of working capital.  This number seems large; although, it is inflated by what appears to be an unusually small amount of working capital.

Productivity may also be measured by profit before taxes or cash flow.  Such values can be substituted into the numerator to create additional measures of productivity.

    Return on Equity (ROE) = Net Income x Net revenue x Total Assets = Net Income
                                                 Net Revenue  Total Assets        Equity               Equity

Return on Equity (or ROE) measures a company’s return on total equity.  You may choose to use average equity in the denominator to adjust for fluctuations.

The ROE formula actually represents ROA times an “equity multiplier.”  This multiplier (the ratio of assets to equity) actually measures leverage.  A higher number indicates a greater proportion of debt financing.  Because of this, the effect of leverage is introduced into the ROE ratio.

The return on equity for Smith Heating and Cooling, Inc. is 4.67 or 467 percent.  While this return seems astronomical, the ROE for this company is an anomaly.  Take a look at the balance sheet.  The company is extremely highly leveraged; its net equity is only $3,000 versus total assets of $706,000.  In fact, the company had a deficit equity position prior to this year’s profit.  This is not a good situation.

Note also that equity is measured by book value, which may differ significantly from market value.

Return on Assets (ROA) = Net Income x Net Revenue = Net Income
                                               Net Revenue  Total Assets    Total Assets

ROA measures return on total assets; it also represents the net profit margin multiplied by asset turnover.  Keep in mind that heavily depreciated buildings, large proportions of intangible assets, or seasonal fluctuations may affect the asset total at a given point in time and throw the ratio off.  Substituting average total assets in the denominator may alleviate the effect of seasonal fluctuations.

You will generally find an inverse relationship between the two ratios comprising return on assets.  A company with a low net profit margin will likely exhibit higher asset turnover and vice versa.  For example, a large discount retailer charges low prices but sells in high volumes.  An analyst may compare returns on assets among companies using different pricing strategies to learn which ones work best.

The ROA for Smith Heating and Cooling, Inc. is .02 or two percent.  Compare this number to those of prior years and to returns on assets of other companies.  Ask yourself whether the $14,000 net profit is typical or sustainable for this company.

The bottom line on the common size income statement is the Net Profit Margin:

    Net Profit Margin = Net Income
                                     Net Revenue

This ratio expresses net income as a percentage of sales, and it is a good indicator of overall profitability.  The net profit margin may be very telling when compared to net profit margins of similar companies.

The net profit margin is also a component of the return on assets (ROA) and return on equity (ROE) ratios, which are additional measures of profitability and efficiency presented in the following sections.

    Asset Turnover = Net Revenue
                                    Total Assets

The Asset Turnover Ratio measures the ability to generate revenues based on total assets.  Average total assets may be substituted in the denominator to adjust for seasonal variations or anomalous asset totals.  Asset turnover for Smith Heating and Cooling, Inc. is 1.42 times.

This ratio is useful when compared to prior years and especially when compared with other companies in the same industry.  Along with the net profit margin, the asset turnover ratio is a component of ROA and ROE.

Smith Heating and Cooling, Inc.<< MORE >>

Smith Heating and Cooling, Inc.<< MORE >>

In the same manner that profit margins are calculated, the entire income statement is often converted to percentages or to a common size.  “Common sizing” refers to the act of restructuring a financial statement into individual percentages of a total.  For the income statement, the percentages are calculated by dividing each line by net sales.  A balance sheet may also be common-sized; in this case each account is measured against total assets.

 

Any individual expense or account may then be studied as a percentage.  It may be particularly useful to measure advertising, officer salaries, or occupancy costs as a percentage of sales.  This allows for more useful comparisons from year-to-year, especially if sales have grown over time.  These numbers may also be telling when compared to those of similar businesses or to competitors.

 

In fact, the most significant benefit of common sizing is that it allows for logical comparison between companies.  This format is essential when using industry averages, which are expressed as percentages.

 

Here is a sample set of benchmarks in a PDF from the Risk Management Association.

 

    Gross Profit Margin = Gross Profit
                                     Net Revenue
 
The Gross Profit Margin expresses gross profit as a percentage of sales.  Gross profit is what remains after cost of good sold (or direct costs) are subtracted from revenues.
 
Note that net (as opposed to gross) revenue is used in profit margins.  Sometimes a company will express “gross sales” less “returns and allowances,” equaling “net sales” on their income statement.  When a business presents both gross and net revenues, it is net revenues that are used in profit margins and common size reports.
 
A higher percentage (or profitability) is obviously desirable for this ratio.  The gross profit margin can be an invaluable indicator of performance and profitability and even pricing strategy when compared with other firms in the industry.  It is among the most basic and widely used financial ratios.
 
    Operating Profit Margin = Operating Profit
                                               Net Revenue
 
The Operating Profit Margin expresses operating profit (or sales, less cost of sales, less operating expenses) as a percentage of sales.  This is also a crucial measure of profitability, which is often compared to industry averages.
 
Company profit margins are also compared from year to year, and trends are studied by management and financial analysts.

    DSC = Net Income + Depreciation + Amortization + Interest Expense
               Total Principal & Interest Payments Required in Upcoming Year
 
This debt service coverage ratio is the most basic and commonly used measure by banks when analyzing whether borrowers will be able to repay commercial loans.  It presents accrual-based cash available to service debt against the actual debt payments that will be required over the next year.  Note that these debt payments cannot be found on the financial statements.  They must be calculated using the payment requirements of lenders.
 
According to this calculation, Smith Heating and Cooling, Inc. has $62,000 available to service debt.  When you add up the monthly debt payments, including interest-only payments on the line of credit and the loan from the owner, the total requirement is around $57,000.  This means that the debt service coverage is about 1.09 times.
 
Banks prefer debt service coverage of at least 120 to 125 percent to be comfortable; this company falls a bit short of that.  It is also important to note that, despite the seemingly adequate coverage measured by the other ratios, when all of the debt service requirements are added up, this one shows only marginal coverage.
 
The most significant flaw with this ratio involves the fact that it is based upon accrual accounting, which does not necessarily measure true cash flow.  We’ll present more about cash flow as our studies progress.