Foreign bonds are considered riskier than domestic bonds because of the unavoidable uncertainty due to exchange rate risk and country risk. The same is true for foreign and domestic common stocks. Such investments as art, antiques, coins, and stamps require heavy liquidity risk premiums. You should divide consideration of real estate investments between your personal home, on which you do not expect as high a return
because of nonmonetary factors, and commercial real estate, which requires a much higher rate of return due to cash flow uncertainty and illiquidity.

Studies on the historical rates of return for investment alternatives (including bonds, commodities, real estate, foreign securities, and art and antiques) point toward two generalizations.

1. A positive relationship typically holds between the rate of return earned on an asset and the variability of its historical rate of    return. This is expected in a world of risk-averse investors who require higher rates of return to compensate for more uncertainty.

2. The correlation among rates of return for selected alternative investments is typically quite low, especially for U.S. and foreign stocks and bonds and between these financial assets and real assets, as represented by art, antiques, and real estate. This confirms the advantage of diversification among investments from around the world.

In addition to make many direct investments, such as stocks and bonds, we also could use investment companies that allow investors to buy investments indirectly. These can be important to investors who want to take advantage of professional management but also want instant diversification with a limited amount of funds. With $10,000, you may not be able to buy many individual stocks or bonds, but you could acquire shares in a mutual fund, which would give you a share of a diversified portfolio that might contain 100 to 150 different U.S. and international stocks or bonds.

Canadian interest rate expectations have risen sharply following improvements in the labor market and a rise in consumer prices. The central bank is expected to remain on hold until mid-2010 but we could see them act aggressively if inflation becomes an issue. Governor Carney in a recent interview stated that their remains considerable slack in the economy and is sticking to the commitment to keep rates low. However, the central bank leader would go on to say that there are signs of stabilization in the labor market and that the housing sector is seeing strength.

U.S. interest expectations have started to stabilize as weaker than expected personal income and spending figures have tempered the outlook for future tightening. Nevertheless, the improvement in both areas reaffirms a recovery is underway which should keep the central bank on track to raise rates sometime in the second half of 2010.

Specially, an investment is the current commitment of dollars for a period of time in order to derive future payments that willcompensate the invester for (1) the time the funds are committed,(2) the expected rate of inflaiton,and (3) the uncertainty of thefuture payments. The “investor” can be an individual, a government, a pension fund, or a corporation. This definition includes all types of investment, including investment by corporations in plant and equipment and investments by individuals in stocks, bonds, commodities, or real estate. In all cases, the investor is trading a known dollar amount today for some expected future stream of payments that will be greater than the current outlay.

A central question is how investors select investments that will give them their required rates of return, that is, how to choose among alternative investment assets. This selection process requires that you must understand how to measure the rate of return and the risk involved in an investment accurately.

Measures of Historical Rates of Return

The period during which you own an investment is called its holding period, and the return for that period is the holding period return (HPR). It is caculated as follows:

HPR = Ending value of investment / Beginning value of investment

This value will always be zero or greater. A value greater than 1.0 reflects an increase in your wealth. A value less than 1.0 means that you suffered an decline in wealth. A HPR of zero indicates that you lost all you money.

Investors generally evaluate returns in percentage terms on an annual basis. The percentage return is referred to as the holding period yield (HPY). The HPY is equal to the HPR minus 1.

HPY = HPR – 1

To derive an annual HPY, you compute an annual HPR and subtract 1. Annual HPR is found by:
Annual HPR = HPR exponent(1/n)
n = number of years the investment is held

Note that we made some implicit assumptions when converting the HPY to an annual basis. This annualized holding period yield computation assumes a constant annual yield for each year.

ROE is calculated as:

      ROE=Net income/Sharesholder’s equity

Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder’s equity does not include preferred shares.

There are several variations on the formula that investors may use:

1. Investors wishing to see the return on common equity may modify the formula above by subtracting preferred dividends from net income and subtracting preferred equity from shareholders’ equity, giving the following:

      return on common equity (ROCE) = net income – preferred dividends / common equity.

2. Return on equity may also be calculated by dividing net income by average shareholders’ equity. Average shareholders’ equity is calculated by adding the shareholders’ equity at the beginning of a period to the shareholders’ equity at period’s end and dividing the result by two.

3. Investors may also calculate the change in ROE for a period by first using the shareholders’ equity figure from the beginning of a period as a denominator to determine the beginning ROE. Then, the end-of-period shareholders’ equity can be used as the denominator to determine the ending ROE. Calculating both beginning and ending ROEs allows an investor to determine the change in profitability over the period.

Return on equity is particularly important because it can help you cut through the garbage spieled out by most CEO’s in their annual reports about, “achieving record earnings”. Warren Buffett pointed out years ago that achieving higher earnings each year is an easy task. Why? Each year, a successful company generates profits. If management did nothing more than retain those earnings and stick them a simple passbook savings account yielding 4% annually, they would be able to report “record earnings” because of the interest they earned. Were the shareholders better off? Not at all; they would have enjoyed heftier returns had the earnings been paid out. This makes obvious that investors cannot look at rising per-share earnings each year as a sign of success. The return on equity figure takes into account the retained earnings from previous years, and tells investors how effectively their capital is being reinvested. Thus, it serves as a far better gauge of management’s fiscal adeptness than the annual earnings per share.

Investors usually look for companies with returns on equity that are high and growing.A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company’s return on equity compared to its industry, the better. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth [shareholder’s equity] of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity [$5 / $100 = .05, or 5%]. The higher you can get the “return” on your equity, in this case 5%, the better.

But not all high-ROE companies make good investments. Some industries have high ROE because they require no assets, such as consulting firms. Other industries require large infrastructure builds before they generate a penny of profit, such as oil refiners. You cannot conclude that consulting firms are better investments than refiners just because of their ROE. Generally, capital-intensive businesses have high barriers toentry, which limit competition. But high-ROE firms with small asset bases have lower barriers to entry. Thus, such firms face more business risk because competitors can replicate their success without having to obtain much outside funding. As with many financial ratios, ROE is best used to compare companies in the same industry.

High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS), you will be paying twice as much (in Price/Book terms) for a 20% ROE company as for a 10% ROE company. The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the company a high growth rate. ROE is presumably irrelevant if the earnings are not reinvested.

The sustainable growth model shows us that when firms pay dividends, earnings growth lowers. If the dividend payout is 20%, the growth expected will be only 80% of the ROE rate. The growth rate will be lower if the earnings are used to buy back shares. If the shares are bought at a multiple of book value (say 3 times book), the incremental earnings returns will be only ‘that fraction’ of ROE (ROE/3).

New investments may not be as profitable as the existing business. Ask “what is the company doing with its earnings?” Remember that ROE is calculated from the company’s perspective, on the company as a whole. Since much financial manipulation is accomplished with new share issues and buyback, always recalculate on a ‘per share’ basis, i.e. earnings per share/book value per share.

ROE encompasses the three pillars of corporate management — profitability, asset management, and financial leverage. By seeing how well the executive team balances these components, investors can not only get an excellent sense of whether they will receive a decent return on equity but can also assess management’s ability to get the job done.The DuPont formula, also known as the strategic profit model, is a common way to break down ROE into three important components. Essentially, ROE will equal net margin multiplied by asset turnover multiplied by financial leverage.

      ROE=(Net income/Sales) * (Sales/total assets)*(Total assets/average stockholders equity)

Splitting return on equity into three parts makes it easier to understand changes in ROE over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more sales for every dollar of assets owned, again resulting in a higher overall ROE. Finally, increasing financial leverage means that the firm uses more debt financing relative to equity financing. Interest payments to creditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher proportion of debt in the firm’s capital structure leads to higher ROE. Financial leverage benefits diminish as the risk of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE decreases. Return on assets is one of the elements used in financial analysis using the Du Pont Identity. and be impacted by inventory directly. Increased debt will make a positive contribution to a firm’s ROE only if the firms ROA exceeds the interest rate on the debt.

There are two acceptable ways to calculate return on assets.

      ROA=Net income/Total assets
      or
      ROA=Net Profit Margin x Asset Turnover

Note: Some investors add interest expense back into net income when performing this calculation because they’d like to use operating returns before cost of borrowing.

The assets of the company are comprised of both debt and equity. Both of these types of financing are used to fund the operations of the company. The ROA figure gives investors an idea of how effectively the company is converting the money it has to invest into net income. The higher the ROA number, the better, because the company is earning more money on less investment. For example, if one company has a net income of $1 million and total assets of $5 million, its ROA is 20%; however, if another company earns the same amount but has total assets of $10 million, it has an ROA of 10%. Based on this example, the first company is better at converting its investment into profit. When you really think about it, management’s most important job is to make wise choices in allocating its resources. Anybody can make a profit by throwing a ton of money at a problem, but very few managers excel at making large profits with little investment.

ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company’s previous ROA numbers or the ROA of a similar company. Capital-intensive industries will yield a low return on assets, since they have to own such expensive assets to do business. Shoestring operations will have a high ROA: their required assets are minimal.Companies such as telecommunication providers, car manufacturers, and railroads are very asset-intensive, meaning they require big, expensive machinery or equipment to generate a profit. Advertising agencies and software companies, on the other hand, are generally very asset-light.

This is an important ratio for companies deciding whether or not to initiate a new project. The basis of this ratio is that if a company is going to start a project they expect to earn a return on it, ROA is the return they would receive. Simply put, if ROA is above the rate that the company borrows at then the project should be accepted, if not then it is rejected. Cory’s Tequila Co.’s ROA is 14% – very high, this is over double the cost of borrowing (at time of writing).

Where asset turnover tells an investor the total sales for each $1 of assets, ROA tells an investor how much profit a company generated for each $1 in assets. It’s a useful number for comparing competing companies in the same industry. The number will vary widely across different industries. Return on assets gives an indication of the capital intensity of the company, which will depend on the industry; companies that require large initial investments will generally have lower return on assets. Companies such as telecommunication providers, car manufacturers, and railroads are very asset-intensive, meaning they require big, expensive machinery or equipment to generate a profit. Advertising agencies and software companies, on the other hand, are generally very asset-light. In the case of a software companies, once a program has been developed, employees simply copy it to a five-cent disk, throw an instruction manual in the box, and mail it out to stores.

Return on assets measures a company’s earnings in relation to all of the resources it had at its disposal [the shareholders’ capital plus short and long-term borrowed funds]. Thus, it is the most stringent and excessive test of return to shareholders. If a company has no debt, it the return on assets and return on equity figures will be the same.

Return on assets is a key profitability measure which can be used to measure relative efficiency of companies within the same industry who have a similar product or service line. ROA is not useful when comparing sectors against each other, companies within different sectors, or even sometimes companies within the same sector. Even though a company may be in the same sector, it does not mean that it will have a similar product or service offering. Typically, this number is most useful when using it as a historical benchmark that a company uses to measure it’s relative performance against past periods.

You can calculate the P/S by dividing the market cap of the stock by the total sales of the company.

      P/S Ratio = Market cap (shares outstanding * market price per share)/Total sales

For example, the P/S ratio is obtained by dividing the market capitalization by the latest published annual sales figure. So a company with a capitalization of $1 billion and sales of $3 billion would have a P/S ratio of 0.33.

You can also calculate the P/S by dividing the current stock price by the sales per share.

      P/S = Stock Price / Sales Price Per Share

P/S will vary with the type of industry. You would expect, for example, that many retailers and other large-scale distributors of goods would have very high sales in relation to their market capitalizations, in other words, a very low P/S. Equally, manufacturers of high-value items would generally have much lower sales figures and thus higher P/S ratios.

“The largest profits regularly result from buying stocks at low P/S ratios.” These were the words of Ken Fisher, whose theoretical work in the early 1970s produced this ratio. He used the measure to value stocks, focusing on companies with P/S ratios less than one.

Much like P/E, the P/S number reflects the value placed on sales by the market. The lower the P/S ratio, the better for value investors. A lower P/S ratio is typically viewed as a better investment primarily because the investor is paying less for each unit of sales.However, this is definitely not a number you want to use in isolation. When dealing with a young company, there are many questions to answer and the P/S supplies just one answer.

Advantages of the P/S Ratio

While earnings figures can easily be manipulated, it is much harder to do so when it comes to sales numbers. Revenues are fairly straightforward and any tweaks can usually be detected rather easily. This is one of the most frequently cited benefits of using the P/S Ratio.

The P/S ratio can also be used to evaluate a firm that has failed to make money in the past year. In highly cyclical industries such as the automobile industry, sometimes it can be quite tough to post a profit. Companies may fail to do so for a few years in a row. While this may lead investors to believe that cyclical stocks are completely worthless, the P/S ratio may say quite the contrary.

Unless the company is heading towards bankruptcy, this ratio, when compared to its peers or the industry average, can tell investors whether or not its sales are being valued at a discount. Let’s say that Reggie’s Diner (fictitious company) reported negative earnings in the past year, but has a P/S ratio of 0.72. The industry in which Reggie’s Diner participates has a P/S ratio of 1.8. This is good news for Reggie’s Diner, assuming it can start making money in the near future.

Disadvantages of the P/S Ratio

A major problem with the P/S ratio is that sales figures do not take debt into account, while earnings do. Companies up to their ears in debt, which may be on the path to bankruptcy, can have low P/S ratios.

Furthermore, the figure does not take expenses into consideration. While expenses play a key role in the calculation of a company’s profits, they have nothing to do with a company’s revenues. Sure a company may be bringing in millions of dollars of revenues, but at what cost? This practice will eventually catch up to a company.

Lastly, an investor should never make a purchase decision based squarely on an appealing P/S ratio. Investors should never use any tool as a one-stop decision maker to uncover stocks that are potentially undervalued.

Profit margin is simply calculated by finding the net profit as a percentage of the revenue.

      Net Profit margin = Net profit (after taxes) / Revenue * 100

A 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.

Profit margin can be useful for comparing or contrasting companies that are within similar industries, but cross-industry comparison may not be as beneficial as profit margins vary greatly depending upon the involved industry. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. A low profit margin can indicate pricing strategy and/or the impact competition has on margins.

Profit margin can also be helpful as simply looking at earnings may not tell as much of a story. Even increased earnings may not mean the company’s financial situation is improving if costs have increased by the same amount or more. Increased earnings are good, but an increase does not mean that the profit margin of a company is improving. For instance, if a company has costs that have increased at a greater rate than sales, it leads to a lower profit margin. This is an indication that costs need to be under better control.

Imagine a company has a net income of $10 million from sales of $100 million, giving it a profit margin of 10% ($10 million/$100 million). If in the next year net income rises to $15 million on sales of $200 million, the company’s profit margin would fall to 7.5%. So while the company increased its net income, it has done so with diminishing profit margins.

Here are a few examples of the net profit margins from the same businesses:

Leisure & Hotels International Airline Manufacturer Retailer Discount Airline Refining Pizza Restaurants Accounting Software 

      Net Profit 7.36% 4.05% -10.48% 1.63% 10.87% 12.63% 7.55% 27.15%

Just like the gross profit margins, the net profit margins also vary from business to business and from industry to industry. When we compare the gross and the net profit margins we can gain a good impression of their non-production and non-direct costs such as administration, marketing and finance costs.

We saw that the international airline’s gross profit margin was the lowest of this group of eight businesses at only 5.62%; but look, its net profit margin is 4.05%, only a little bit lower than its gross profit margin. On the other hand, the discount airline’s gross profit margin is 27.46% but its net profit margin is a lot less than that at 10.87%. As we just said, these comparisons give us a great insight into the cost structure of these businesses.

Look at the software business too, a very high gross profit margin of 89.55% but a net profit margin of 27.15%. This is still high, but we can now see that the administration and similar expenses are very high whilst its cost of sales and operating costs are relatively very low.

It is worth analyzing the ratio over time. A variation in the ratio from year to year may be due to abnormal conditions or expenses. Variations may also indicate cost blowouts which need to be addressed. A decline in the ratio over time may indicate a margin squeeze suggesting that productivity improvements may need to be initiated. In some cases, the costs of such improvements may lead to a further drop in the ratio or even losses before increased profitability is achieved.