I still remember the moment everything clicked. It was 2016, and I was staring at two nearly identical tech companies—same sector, similar revenues, both "highly recommended" by analysts. But when I calculated their Return on Equity (ROE), the difference was staggering: Company A generated 28% returns on shareholder capital while Company B struggled at 11%. Three years later, Company A had tripled while Company B languished. That single formula—ROE = Net Income / Shareholder Equity—saved me from a mediocre investment and launched my journey into systematic fundamental analysis. Financial formulas aren't just academic exercises; they're the X-ray vision that reveals what companies really look like beneath the surface. This guide will transform you from a casual stock picker into a data-driven investor who speaks the language of professional analysts. Every formula, every ratio, every metric—explained with real examples and practical applications.
Complete Financial Ratios Reference Table
Below is your complete quick-reference guide to all essential financial ratios. Use this table to quickly look up any formula, then dive into the detailed explanations that follow.
Financial Ratios Master Reference
| Financial Ratio | Formula |
|---|---|
| Current Ratio | Current Assets / Current Liabilities |
| Quick Ratio | (Cash + Short-Term Investments + Receivables) / Current Liabilities |
| Cash Ratio | Cash & Cash Equivalents / Current Liabilities |
| Working Capital | Total Current Assets - Total Current Liabilities |
| Price-to-Earnings (P/E) | Price / (Net Income / Shares Outstanding) |
| Price-to-Sales (P/S) | Price / (Revenue / Shares Outstanding) |
| Price-to-Cash Flow (P/CF) | Price / (Operating Cash Flow / Shares Outstanding) |
| Price-to-Free Cash Flow (P/FCF) | Market Cap / Free Cash Flow |
| Price-to-Book (P/B) | Price / (Total Equity / Shares Outstanding) |
| Price Earnings to Growth (PEG) | P/E Ratio / EPS Growth Rate |
| Enterprise Value (EV) | Market Cap - Cash & Equivalents + Total Debt |
| EV-to-Sales | Enterprise Value / Revenue |
| EV/EBITDA | Enterprise Value / EBITDA |
| EV-to-Operating Cash Flow | Enterprise Value / Operating Cash Flow |
| Enterprise Value Multiplier | Enterprise Value / EBITDA |
| Earnings Yield | (Net Income / Shares Outstanding) / Price |
| Free Cash Flow Yield | Free Cash Flow / Market Cap |
| Debt-to-Equity | Long-Term Debt / Total Equity |
| Debt-to-Assets | Long-Term Debt / Total Assets |
| Debt Ratio | Total Liabilities / Total Assets |
| Debt Equity Ratio | Total Liabilities / Total Equity |
| Long-Term Debt to Capitalization | Debt / (Debt + Total Equity) |
| Total Debt to Capitalization | (Debt + Short-Term Debt) / (Short-Term Debt + Debt + Total Equity) |
| Net Debt-to-EBITDA | (Total Debt - Cash & Equivalents) / EBITDA |
| Interest Coverage | EBIT / Interest Expense |
| Cash Flow to Debt Ratio | Operating Cash Flow / Total Debt |
| Cash Flow Coverage Ratio | Operating Cash Flow / (Short-Term Debt + Debt) |
| Short-Term Coverage Ratio | Operating Cash Flow / Short-Term Debt |
| Income Quality | Operating Cash Flow / Net Income |
| Dividend Yield | (Dividends Paid / Shares Outstanding) / Price |
| Payout Ratio | Dividends Paid / Net Income |
| Gross Profit Margin | Gross Profit / Revenue |
| Operating Profit Margin | Operating Income / Revenue |
| Pretax Profit Margin | Income Before Tax / Revenue |
| Net Profit Margin | Net Income / Revenue |
| Effective Tax Rate | Income Taxes / Income Before Tax |
| Return on Assets (ROA) | Net Income / Total Assets |
| Return on Equity (ROE) | Net Income / Total Equity |
| Return on Tangible Assets | Net Income / (Total Assets - Intangible Assets) |
| Return on Capital Employed (ROCE) | Operating Profit / ((Avg Total Assets - Avg Current Liabilities) / 2) |
| Return on Invested Capital (ROIC) | Operating Profit × (1 - Tax Rate) / (Total Equity + Total Long-Term Debt) |
| Sales General & Admin to Revenue | SG&A Expenses / Revenue |
| Tangible Asset Value | Total Assets - Intangible Assets - Total Liabilities |
| Net Current Asset Value | Total Current Assets - Total Liabilities |
| Receivables Turnover | Revenue / Accounts Receivable |
| Days Sales Outstanding (DSO) | ((AR Start + AR End) / 2) / (Revenue / 365) |
| Days Inventory Outstanding (DIO) | ((Inventory Start + Inventory End) / 2) / (COGS / 365) |
| Days Payables Outstanding (DPO) | ((AP Start + AP End) / 2) / (COGS / 365) |
| Operating Cycle | DSO + DIO |
| Cash Conversion Cycle | DSO + DIO - DPO |
| Revenue Per Share | Revenue / Shares Outstanding |
| Capex Per Share | Capital Expenditures / Shares Outstanding |
| Interest Debt Per Share | (Debt + Short-Term Debt + Interest Expense) / Shares Outstanding |
| Company Equity Multiplier | Total Assets / Total Equity |
| Net Income Per EBT | Net Income / Income Before Taxes |
| EBT Per EBIT | EBT / EBIT |
| EBIT Per Revenue | EBIT / Revenue |
| Asset Turnover | Revenue / Total Assets |
| Fixed Asset Turnover | Revenue / Net PP&E |
| Operating Cash Flow Sales Ratio | Operating Cash Flow / Revenue |
| Free Cash Flow to Operating Cash Flow | Free Cash Flow / Operating Cash Flow |
| Capital Expenditure Coverage Ratio | Operating Cash Flow / Capital Expenditures |
| Dividend and Capex Coverage Ratio | Operating Cash Flow / (Capex + Dividends Paid) |
| Price Fair Value | Price / Intrinsic Value |
| Beta | Monthly price change of stock relative to S&P500 (5-year period) |
Note: This comprehensive table includes all major financial ratios used in fundamental analysis. Each ratio is explained in detail in the sections that follow.
Why Financial Formulas Are Your Competitive Advantage
The stock market is fundamentally a voting machine in the short term and a weighing machine in the long term. Financial formulas give you the scale to weigh companies accurately while others rely on gut feelings and hot tips.
Research from the CFA Institute shows that investors who systematically apply fundamental analysis outperform those who don't by an average of 3.2% annually. Over 30 years of investing, that compounds to an astonishing 157% difference in total returns—the gap between comfortable retirement and extraordinary wealth.
"In God we trust, all others must bring data. Financial ratios are the language of business—if you can't speak it fluently, you're investing blind." - W. Edwards Deming (adapted)
Professional analysts spend 70% of their time calculating and interpreting financial metrics. Retail investors who master these same formulas suddenly compete on equal footing with the pros. The playing field doesn't level often in investing—this is your chance.
Understanding Financial Statements: The Foundation
Before diving into formulas, you must understand where the numbers come from. Every public company publishes three critical financial statements quarterly and annually:
The Three Financial Statements
1. Income Statement (Profit & Loss)
- Shows revenues, expenses, and profits over a period
- Answers: "How profitable is this company?"
- Key items: Revenue, Operating Income, Net Income
- Frequency: Quarterly (10-Q) and Annual (10-K)
2. Balance Sheet (Financial Position)
- Snapshot of assets, liabilities, and equity at a point in time
- Answers: "What does the company own vs. owe?"
- Key items: Total Assets, Total Liabilities, Shareholder Equity
- Equation: Assets = Liabilities + Equity
3. Cash Flow Statement (Money Movement)
- Tracks actual cash in and out of the business
- Answers: "Is the company generating real cash?"
- Key sections: Operating, Investing, Financing activities
- Critical metric: Free Cash Flow
Profitability Ratios: Measuring Earning Power
Profitability ratios reveal how effectively a company converts revenue into profit. These are your first stop in fundamental analysis—no profit, no sustainable business.
Gross Profit Margin: The Product Economics Test
Gross Profit Margin Formula
Formula: Gross Profit Margin = (Gross Profit / Revenue) × 100
Components:
- Gross Profit = Revenue - Cost of Goods Sold (COGS)
- Revenue = Total sales from products/services
- COGS = Direct costs to produce goods/services
Example: Apple Inc. (2023)
- Revenue: $383.3 billion
- COGS: $214.1 billion
- Gross Profit: $169.2 billion
- Gross Margin: ($169.2B / $383.3B) × 100 = 44.1%
Interpretation:
- Apple keeps $44.10 of every $100 in sales after production costs
- Above 40% = Excellent (strong pricing power)
- 20-40% = Good (solid business)
- Below 20% = Weak (commodity business, price competition)
What to Look For:
- Increasing margins over time: Pricing power, operational efficiency
- Decreasing margins: Competition intensifying, cost pressures
- Stable high margins (40%+): Durable competitive advantages
- Industry comparison critical: Software (80%+) vs. Retail (25%)
Operating Profit Margin: The Business Model Quality
Operating Profit Margin Formula
Formula: Operating Profit Margin = (Operating Income / Revenue) × 100
Components:
- Operating Income = Gross Profit - Operating Expenses
- Operating Expenses = SG&A + R&D + Depreciation
- Excludes: Interest, taxes, one-time items
Example: Microsoft (2023)
- Revenue: $211.9 billion
- Operating Income: $88.5 billion
- Operating Margin: ($88.5B / $211.9B) × 100 = 41.8%
Interpretation:
- Microsoft generates $41.80 in operating profit per $100 revenue
- Above 20% = Exceptional operating efficiency
- 10-20% = Healthy business
- Below 10% = Operational challenges or low-margin sector
Why It Matters: Operating margin reveals core business health independent of financing decisions or tax strategies. Companies can manipulate net income through debt restructuring or tax maneuvers, but operating income shows true operational performance.
Net Profit Margin: The Bottom Line Reality
Net Profit Margin Formula
Formula: Net Profit Margin = (Net Income / Revenue) × 100
Components:
- Net Income = Operating Income - Interest - Taxes - Other Items
- This is the final "bottom line" profit
- What's left for shareholders after all expenses
Example: Walmart (2023)
- Revenue: $611.3 billion
- Net Income: $15.5 billion
- Net Margin: ($15.5B / $611.3B) × 100 = 2.5%
Interpretation:
- Walmart keeps $2.50 profit from every $100 in sales
- Above 20% = Outstanding (software, pharma)
- 10-20% = Strong (branded goods)
- 5-10% = Acceptable (many industries)
- Below 5% = Low-margin business (retail, groceries)
Return on Assets (ROA): Asset Efficiency
Return on Assets Formula
Formula: ROA = (Net Income / Total Assets) × 100
Components:
- Net Income = From income statement
- Total Assets = From balance sheet
- Measures how efficiently assets generate profits
Example: Johnson & Johnson (2023)
- Net Income: $35.1 billion
- Total Assets: $187.4 billion
- ROA: ($35.1B / $187.4B) × 100 = 18.7%
Interpretation:
- Every dollar of assets generates $0.187 in profit
- Above 15% = Excellent asset utilization
- 8-15% = Good performance
- Below 5% = Asset-heavy, low returns
Industry Context Crucial:
- Software companies: 15-30% ROA (minimal assets needed)
- Manufacturing: 5-10% ROA (heavy equipment investment)
- Banks: 0.8-1.5% ROA (huge balance sheets)
- Utilities: 2-4% ROA (infrastructure-intensive)
Return on Equity (ROE): The Shareholder's Return
Return on Equity Formula
Formula: ROE = (Net Income / Total Shareholder Equity) × 100
Components:
- Net Income = Profit attributable to shareholders
- Shareholder Equity = Assets - Liabilities
- Shows return generated on shareholders' investment
Example: NVIDIA (2023)
- Net Income: $29.8 billion
- Shareholder Equity: $42.9 billion
- ROE: ($29.8B / $42.9B) × 100 = 69.5%
Interpretation:
- Every dollar of equity generates $0.695 in profit
- Above 20% = Exceptional (Warren Buffett's threshold)
- 15-20% = Very good
- 10-15% = Acceptable
- Below 10% = Underwhelming returns
The Warren Buffett Standard: Buffett historically targets companies with ROE consistently above 15%, preferably 20%+. His rationale: If a company can't generate at least 15% returns on retained earnings, shareholders would be better off receiving dividends to invest elsewhere.
ROE Warning: The Debt Trap
High ROE can be artificially inflated through excessive debt. Consider two companies:
Company A (Healthy High ROE):
- Net Income: $100M
- Equity: $500M
- Debt: $200M
- ROE: 20%
Company B (Debt-Fueled ROE):
- Net Income: $100M
- Equity: $200M
- Debt: $1,000M
- ROE: 50%
Company B's spectacular 50% ROE comes from financial engineering, not operational excellence. During downturns, that massive debt becomes a liability that can destroy the business.
Solution: Always check ROE alongside Debt-to-Equity ratio. Ideal: High ROE with low debt.
Liquidity Ratios: Measuring Financial Health
Profitability means nothing if a company can't pay its bills. Liquidity ratios reveal whether a company has sufficient short-term resources to meet obligations. Many profitable companies have gone bankrupt due to liquidity crises.
Current Ratio: The Quick Health Check
Current Ratio Formula
Formula: Current Ratio = Current Assets / Current Liabilities
Components:
- Current Assets = Assets convertible to cash within 12 months
- Includes: Cash, receivables, inventory, marketable securities
- Current Liabilities = Debts due within 12 months
- Includes: Accounts payable, short-term debt, accrued expenses
Example: Amazon (2023)
- Current Assets: $168.6 billion
- Current Liabilities: $155.4 billion
- Current Ratio: $168.6B / $155.4B = 1.08
Interpretation:
- Amazon has $1.08 in current assets per $1.00 of current liabilities
- Above 2.0 = Very safe (potentially too conservative)
- 1.5-2.0 = Healthy cushion
- 1.0-1.5 = Adequate but watch closely
- Below 1.0 = Liquidity concerns (red flag)
Context Matters:
- Retail companies: Can operate with lower ratios (1.0-1.5) due to fast inventory turnover
- Manufacturing: Need higher ratios (1.5-2.5) due to longer cycles
- Tech/Software: Often very high ratios (3.0+) with cash hoards
Quick Ratio (Acid Test): The Stress Test
Quick Ratio Formula
Formula: Quick Ratio = (Current Assets - Inventory) / Current Liabilities
Alternative: (Cash + Marketable Securities + Receivables) / Current Liabilities
Why Exclude Inventory:
- Inventory can't always be quickly converted to cash
- Fire sales of inventory typically yield pennies on the dollar
- Shows liquidity without relying on selling products
Example: Tesla (2023)
- Current Assets: $49.1 billion
- Inventory: $13.6 billion
- Current Liabilities: $28.7 billion
- Quick Ratio: ($49.1B - $13.6B) / $28.7B = 1.24
Interpretation:
- Even without selling inventory, Tesla covers obligations 1.24x
- Above 1.5 = Very strong liquidity
- 1.0-1.5 = Adequate liquidity
- 0.75-1.0 = Potential concerns
- Below 0.75 = Serious liquidity risk
Cash Ratio: The Ultimate Conservative Test
Cash Ratio Formula
Formula: Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
Components:
- Cash = Physical currency and bank deposits
- Cash Equivalents = Highly liquid, short-term investments
- Current Liabilities = Debts due within 12 months
Example: Apple (2023)
- Cash + Equivalents: $29.1 billion
- Current Liabilities: $133.0 billion
- Cash Ratio: $29.1B / $133.0B = 0.22
Interpretation:
- Apple could cover 22% of current liabilities with just cash
- Above 0.5 = Extremely conservative (possibly inefficient)
- 0.3-0.5 = Strong cash position
- 0.2-0.3 = Adequate for most businesses
- Below 0.2 = Reliant on operations/credit to meet obligations
When Cash Ratio Matters Most:
- During economic downturns when credit freezes
- For companies in cyclical industries
- When evaluating bankruptcy risk
- For businesses with lumpy cash flows
Solvency Ratios: Long-Term Financial Stability
While liquidity ratios examine short-term survival, solvency ratios reveal long-term sustainability. Can the company meet all its obligations over time? Will it survive the next recession?
Debt-to-Equity Ratio: The Leverage Gauge
Debt-to-Equity Formula
Formula: Debt-to-Equity = Total Debt / Total Shareholder Equity
Components:
- Total Debt = Long-term debt + Short-term debt
- Shareholder Equity = Assets - Liabilities
- Measures how much debt vs. equity finances the business
Example: Ford Motor Company (2023)
- Total Debt: $145.6 billion
- Shareholder Equity: $47.8 billion
- Debt-to-Equity: $145.6B / $47.8B = 3.05
Interpretation:
- Ford has $3.05 in debt for every $1.00 of equity
- Below 0.5 = Conservative (underlevered)
- 0.5-1.0 = Moderate leverage (balanced)
- 1.0-2.0 = High leverage (monitor closely)
- Above 2.0 = Very high leverage (significant risk)
Industry Benchmarks Critical:
- Utilities: 1.5-2.5 D/E normal (predictable cash flows support debt)
- Technology: 0.0-0.5 D/E typical (asset-light, debt unnecessary)
- Real Estate: 2.0-4.0 D/E common (leveraged by nature)
- Auto Manufacturing: 2.0-3.0 D/E standard (capital-intensive)
Debt-to-Assets Ratio: The Ownership Perspective
Debt-to-Assets Formula
Formula: Debt-to-Assets = Total Debt / Total Assets
Components:
- Total Debt = All interest-bearing liabilities
- Total Assets = Everything the company owns
- Shows what percentage of assets are debt-financed
Example: Walmart (2023)
- Total Debt: $63.7 billion
- Total Assets: $252.5 billion
- Debt-to-Assets: $63.7B / $252.5B = 0.25 or 25%
Interpretation:
- 25% of Walmart's assets are financed by debt
- Below 30% = Conservative (low risk)
- 30-50% = Moderate (typical for many companies)
- 50-70% = High (elevated risk)
- Above 70% = Very high (substantial bankruptcy risk)
Interest Coverage Ratio: The Debt Service Reality Check
Interest Coverage Formula
Formula: Interest Coverage = EBIT / Interest Expense
Alternative Names: Times Interest Earned (TIE)
Components:
- EBIT = Earnings Before Interest and Taxes
- Interest Expense = Annual interest payments on debt
- Measures how easily company can pay debt interest
Example: Coca-Cola (2023)
- EBIT: $12.4 billion
- Interest Expense: $1.5 billion
- Interest Coverage: $12.4B / $1.5B = 8.27x
Interpretation:
- Coca-Cola earns 8.27x more than its interest payments
- Above 8.0x = Excellent (very safe)
- 5.0-8.0x = Good (comfortable cushion)
- 2.5-5.0x = Adequate (manageable but monitor)
- 1.5-2.5x = Weak (vulnerable to earnings decline)
- Below 1.5x = Distressed (cannot cover interest from earnings)
Critical During Recessions: When earnings fall 30-50% during downturns, companies with interest coverage below 3.0x often face bankruptcy. Those above 5.0x typically survive comfortably.
Real-World Example: Sears Bankruptcy
Sears Holdings' descent into bankruptcy was telegraphed by deteriorating solvency ratios:
2012 (Warning Signs):
- Interest Coverage: 2.1x (weak)
- Debt-to-Equity: 3.2 (high)
- Debt-to-Assets: 0.58 (concerning)
2015 (Critical):
- Interest Coverage: 0.8x (cannot cover interest)
- Debt-to-Equity: -12.4 (negative equity!)
- Debt-to-Assets: 1.87 (liabilities exceed assets)
2018: Bankruptcy filed
Investors monitoring solvency ratios had 6 years to exit before total loss. The signals were unmistakable by 2015.
Valuation Metrics: What Should You Pay?
Profitability, liquidity, and solvency tell you if a company is good. Valuation tells you if the stock is a good investment. The difference is everything—even great companies make terrible investments if overpriced.
Price-to-Earnings (P/E) Ratio: The Valuation Workhorse
P/E Ratio Formula
Formula: P/E Ratio = Stock Price / Earnings Per Share
Alternative: P/E = Market Capitalization / Net Income
Components:
- Stock Price = Current trading price per share
- Earnings Per Share (EPS) = Net Income / Shares Outstanding
- Shows how many years of earnings you pay for
Example: Meta (Facebook) - January 2024
- Stock Price: $395
- EPS (TTM): $14.87
- P/E Ratio: $395 / $14.87 = 26.6x
Interpretation:
- Investors pay $26.60 for every $1 of annual earnings
- Below 10x = Undervalued or distressed
- 10-20x = Fair value for many mature companies
- 20-30x = Premium (requires growth justification)
- Above 30x = Expensive (better be exceptional)
Forward P/E vs. Trailing P/E:
- Trailing P/E: Based on last 12 months actual earnings (TTM)
- Forward P/E: Based on analyst estimates for next 12 months
- Use trailing for certainty, forward for growth stocks
PEG Ratio: P/E Adjusted for Growth
PEG Ratio Formula
Formula: PEG = (P/E Ratio) / (Earnings Growth Rate)
Components:
- P/E Ratio = Price-to-Earnings ratio
- Growth Rate = Expected annual EPS growth rate (%)
- Normalizes valuation across different growth profiles
Example: Amazon (2024)
- P/E Ratio: 48x
- Expected EPS Growth: 25% annually
- PEG: 48 / 25 = 1.92
Interpretation:
- Below 1.0 = Undervalued relative to growth
- 1.0-2.0 = Fairly valued (sweet spot)
- Above 2.0 = Overvalued relative to growth
- Above 3.0 = Significantly overpriced
Peter Lynch's PEG Principle: Lynch famously sought stocks with PEG ratios below 1.0, calling them "growth at a reasonable price" (GARP). A stock growing 25% annually with a P/E of 20 (PEG = 0.8) offers better value than one growing 10% with P/E of 15 (PEG = 1.5).
Price-to-Book (P/B) Ratio: The Asset Valuation
Price-to-Book Formula
Formula: P/B = Stock Price / Book Value Per Share
Alternative: P/B = Market Cap / Total Shareholder Equity
Components:
- Book Value = Total Assets - Total Liabilities
- Book Value Per Share = Book Value / Shares Outstanding
- Compares market value to accounting value
Example: Bank of America (2024)
- Stock Price: $34
- Book Value Per Share: $32.15
- P/B Ratio: $34 / $32.15 = 1.06
Interpretation:
- Market values BofA at 1.06x its accounting book value
- Below 1.0 = Trading below liquidation value
- 1.0-3.0 = Normal for asset-heavy businesses
- 3.0-10.0 = Typical for strong brands/intangibles
- Above 10.0 = Asset-light (software) or overvalued
When P/B Matters Most:
- Banks: Assets = business (typically trade at 0.8-1.5x book)
- Insurance: Asset-backed (1.0-2.0x book normal)
- Real Estate: Tangible assets (0.8-1.2x book)
- Manufacturing: Equipment value matters (1.5-3.0x book)
When P/B Doesn't Matter:
- Software: Value in code/customers, not assets
- Services: Human capital doesn't appear on balance sheet
- Tech: Intellectual property often not booked at real value
Enterprise Value (EV): The Takeover Price
Enterprise Value Formula
Formula: EV = Market Cap + Total Debt - Cash & Equivalents
Extended Formula: EV = Market Cap + Total Debt + Preferred Stock + Minority Interest - Cash
Components:
- Market Cap = Share Price × Shares Outstanding
- Total Debt = Short-term + Long-term debt
- Cash = Cash and cash equivalents
- Represents total acquisition cost
Example: Netflix (2024)
- Market Cap: $210 billion
- Total Debt: $14.5 billion
- Cash: $7.1 billion
- EV: $210B + $14.5B - $7.1B = $217.4 billion
Why EV Matters:
- Acquiring company pays market cap to shareholders
- Must also assume debt obligations ($14.5B)
- But receives cash on balance sheet ($7.1B)
- True acquisition cost = $217.4B
EV/EBITDA: The Cash Flow Valuation
EV/EBITDA Formula
Formula: EV/EBITDA = Enterprise Value / EBITDA
Components:
- Enterprise Value = Market Cap + Debt - Cash
- EBITDA = Earnings Before Interest, Taxes, Depreciation, Amortization
- Measures valuation relative to cash generation
Example: Starbucks (2024)
- Enterprise Value: $110 billion
- EBITDA: $7.8 billion
- EV/EBITDA: $110B / $7.8B = 14.1x
Interpretation:
- Starbucks valued at 14.1x its cash generation
- Below 8x = Undervalued or distressed
- 8-12x = Fair value for mature companies
- 12-15x = Premium but reasonable
- Above 15x = Expensive (needs growth story)
Why Professionals Prefer EV/EBITDA over P/E:
- Normalizes across different capital structures
- Debt doesn't affect EBITDA (unlike net income)
- Better for comparing companies with different leverage
- Closer approximation of cash flow than earnings
- Standard for M&A valuation
Free Cash Flow Yield: The Real Return
Free Cash Flow Yield Formula
Formula: FCF Yield = (Free Cash Flow / Market Cap) × 100
Components:
- Free Cash Flow = Operating Cash Flow - Capital Expenditures
- Market Cap = Current total company value
- Shows cash return on investment
Example: Visa (2024)
- Free Cash Flow: $17.9 billion
- Market Cap: $520 billion
- FCF Yield: ($17.9B / $520B) × 100 = 3.4%
Interpretation:
- Visa generates 3.4% cash yield on market value
- Above 8% = Excellent value
- 5-8% = Good value
- 3-5% = Fair (typical for quality companies)
- Below 3% = Expensive
Compare to Bond Yields: If 10-year Treasuries yield 4.5% and a stock yields 3% FCF, you're accepting lower yield for growth potential. FCF yield > Treasury yield suggests good value; FCF yield significantly lower requires strong growth to justify.
Efficiency Ratios: Operational Excellence
Efficiency ratios reveal how well management deploys resources. Two companies with identical sales can have vastly different profits based on operational efficiency.
Asset Turnover: Revenue per Dollar of Assets
Asset Turnover Formula
Formula: Asset Turnover = Revenue / Average Total Assets
Components:
- Revenue = Total sales for the period
- Average Assets = (Beginning Assets + Ending Assets) / 2
- Measures revenue generation from assets
Example: Target (2023)
- Revenue: $107.4 billion
- Average Total Assets: $54.2 billion
- Asset Turnover: $107.4B / $54.2B = 1.98
Interpretation:
- Target generates $1.98 in revenue per $1 of assets
- Above 2.0 = Excellent efficiency (lean operations)
- 1.0-2.0 = Good (typical for most industries)
- 0.5-1.0 = Acceptable for capital-intensive sectors
- Below 0.5 = Inefficient or very asset-heavy
Inventory Turnover: How Fast Products Sell
Inventory Turnover Formula
Formula: Inventory Turnover = Cost of Goods Sold / Average Inventory
Days Inventory: 365 / Inventory Turnover
Components:
- COGS = Direct costs to produce sold goods
- Average Inventory = (Beginning + Ending Inventory) / 2
- Shows how many times inventory sold/replaced
Example: Costco (2023)
- COGS: $226.4 billion
- Average Inventory: $17.9 billion
- Inventory Turnover: $226.4B / $17.9B = 12.6x
- Days Inventory: 365 / 12.6 = 29 days
Interpretation:
- Costco sells through entire inventory every 29 days
- Above 10x = Exceptional (groceries, fast fashion)
- 6-10x = Good (most retail)
- 3-6x = Acceptable (general merchandise)
- Below 3x = Slow-moving (luxury, automotive)
Why High Turnover Matters:
- Less capital tied up in inventory
- Fresher products (critical for food/fashion)
- Lower risk of obsolescence
- Better cash conversion cycle
- Competitive advantage in thin-margin businesses
Receivables Turnover: Collection Efficiency
Receivables Turnover Formula
Formula: Receivables Turnover = Revenue / Average Accounts Receivable
Days Sales Outstanding (DSO): 365 / Receivables Turnover
Components:
- Revenue = Total sales (preferably credit sales)
- Accounts Receivable = Money owed by customers
- Measures how quickly company collects payments
Example: Oracle (2023)
- Revenue: $49.9 billion
- Average Receivables: $5.8 billion
- Receivables Turnover: $49.9B / $5.8B = 8.6x
- DSO: 365 / 8.6 = 42 days
Interpretation:
- Oracle collects payment in average 42 days
- Below 30 days = Excellent collections
- 30-45 days = Good (typical B2B)
- 45-60 days = Acceptable but monitor
- Above 60 days = Collection problems or loose terms
Warning Signs:
- DSO increasing: Customers paying slower (cash flow problem brewing)
- DSO > payment terms: If terms are net-30 but DSO is 60, collections failing
- Revenue up, DSO up: Potentially loosening credit to boost sales (red flag)
Growth Metrics: Trajectory Indicators
While ratios provide snapshots, growth metrics reveal direction. A company with moderate metrics but accelerating growth often outperforms one with great metrics but decelerating growth.
Revenue Growth Rate
Revenue Growth Formula
YoY Formula: Revenue Growth = ((Current Year Revenue - Previous Year Revenue) / Previous Year Revenue) × 100
CAGR Formula: CAGR = ((Ending Revenue / Beginning Revenue)^(1/Years)) - 1
Example: Shopify (2019-2023)
- 2019 Revenue: $1.58 billion
- 2023 Revenue: $7.06 billion
- CAGR: (($7.06B / $1.58B)^(1/4)) - 1 = 45.4%
Growth Tiers:
- Above 30% = Hypergrowth (rare, unsustainable long-term)
- 20-30% = Exceptional growth
- 10-20% = Strong growth
- 5-10% = Moderate growth
- Below 5% = Mature/slow growth
Earnings Growth Rate
Earnings Growth Formula
Formula: EPS Growth = ((Current EPS - Prior EPS) / Prior EPS) × 100
Example: NVIDIA (2023-2024)
- 2023 EPS: $3.34
- 2024 EPS: $11.93
- EPS Growth: (($11.93 - $3.34) / $3.34) × 100 = 257%
Quality Check:
- EPS growth > Revenue growth = Margin expansion (excellent)
- EPS growth = Revenue growth = Stable margins (good)
- EPS growth < Revenue growth = Margin compression (concerning)
Dividend Metrics: Income Investor's Toolkit
For income-focused investors, dividend metrics matter as much as growth metrics. These formulas reveal sustainability and value of dividend streams.
Dividend Yield
Dividend Yield Formula
Formula: Dividend Yield = (Annual Dividend Per Share / Stock Price) × 100
Example: AT&T (2024)
- Annual Dividend: $1.11 per share
- Stock Price: $18.50
- Dividend Yield: ($1.11 / $18.50) × 100 = 6.0%
Interpretation:
- Above 6% = Very high (verify sustainability)
- 4-6% = High yield (typical utilities/REITs)
- 2-4% = Moderate (many mature companies)
- 1-2% = Low (growth companies)
- 0% = No dividend (reinvesting in growth)
Warning: Extremely high yields (8%+) often signal market concerns about dividend sustainability. When stock price crashes, yield spikes mechanically—it's a warning, not an opportunity.
Payout Ratio: Sustainability Check
Payout Ratio Formula
Formula: Payout Ratio = (Dividends Per Share / Earnings Per Share) × 100
Alternative: (Total Dividends / Net Income) × 100
Example: Procter & Gamble (2023)
- EPS: $6.02
- Dividend Per Share: $3.65
- Payout Ratio: ($3.65 / $6.02) × 100 = 60.6%
Interpretation:
- Below 30% = Very safe, room to grow
- 30-50% = Safe, sustainable
- 50-70% = Moderate (limited growth room)
- 70-90% = High (vulnerable to cuts)
- Above 90% = Unsustainable (cut likely)
Advanced Formulas: Professional-Grade Analysis
DuPont Analysis: Deconstructing ROE
DuPont Formula (3-Factor)
Formula: ROE = (Net Margin) × (Asset Turnover) × (Equity Multiplier)
Expanded: ROE = (Net Income / Revenue) × (Revenue / Assets) × (Assets / Equity)
Example: Home Depot (2023)
- Net Margin: 10.5% ($16.4B / $157.4B)
- Asset Turnover: 2.1x ($157.4B / $75.3B)
- Equity Multiplier: -6.8x ($75.3B / -$11.0B)
- ROE: 10.5% × 2.1 × -6.8 = -150% (negative equity from buybacks)
What Each Component Reveals:
- Net Margin: Profitability (10.5% is excellent for retail)
- Asset Turnover: Efficiency (2.1x is strong)
- Equity Multiplier: Leverage (negative equity common in mature retailers)
Why DuPont Matters: Two companies can have identical 20% ROE, but achieve it differently:
- Company A: 20% margin × 1.0 turnover × 1.0 leverage = High-margin business
- Company B: 5% margin × 2.0 turnover × 2.0 leverage = Leveraged, high-volume
Company A's ROE is more sustainable; Company B's depends on maintaining debt and volume.
Altman Z-Score: Bankruptcy Prediction
Altman Z-Score Formula
Formula: Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
Where:
- A = Working Capital / Total Assets
- B = Retained Earnings / Total Assets
- C = EBIT / Total Assets
- D = Market Value of Equity / Total Liabilities
- E = Sales / Total Assets
Interpretation:
- Above 2.99 = Safe zone (low bankruptcy risk)
- 1.81-2.99 = Grey zone (monitor closely)
- Below 1.81 = Distress zone (high bankruptcy risk)
Putting It All Together: The Complete Analysis Framework
The 5-Minute Stock Screen
Step 1: Valuation (2 minutes)
- P/E ratio vs. sector average
- PEG ratio (target: below 2.0)
- EV/EBITDA vs. peers
- Decision: Fairly valued or pass
Step 2: Profitability (1 minute)
- ROE trend (target: 15%+, increasing)
- Net margin trend (stable or expanding)
- Decision: Profitable business or pass
Step 3: Financial Health (1 minute)
- Current ratio (above 1.5 preferred)
- Debt-to-Equity (below sector average)
- Interest coverage (above 5x)
- Decision: Financially sound or pass
Step 4: Growth (1 minute)
- Revenue CAGR last 3 years
- EPS CAGR last 3 years
- Decision: Growing or mature
Common Formula Mistakes to Avoid
The Seven Deadly Calculation Errors
1. Comparing Across Industries
- Error: Rejecting bank stock with 1% ROA vs. software 20% ROA
- Fix: Always compare within same sector
2. Ignoring Negative Numbers
- Error: Calculating P/E with negative earnings
- Fix: P/E meaningless with losses; use P/S or EV/Sales
3. Using Single Period Data
- Error: Basing decisions on one quarter's metrics
- Fix: Analyze trends over 3-5 years minimum
4. Forgetting Share Dilution
- Error: Not adjusting for changing share count
- Fix: Always use per-share metrics or check dilution
5. Mixing Trailing and Forward Data
- Error: Forward P/E with trailing revenue growth
- Fix: Consistency in time periods across all metrics
6. Ignoring Extraordinary Items
- Error: Using net income that includes $2B lawsuit settlement
- Fix: Normalize earnings by removing one-time items
7. Believing Formulas Are Absolute Truth
- Error: Selling because P/E hit predetermined threshold
- Fix: Use formulas as guides, not gospel; context matters
Automating Formula Analysis with StockAlert.pro
Calculating these formulas manually for every stock in your watchlist is overwhelming. This is where intelligent automation transforms your investing process.
Smart Alert Strategy: Formula-Based Triggers
Value Opportunity Alerts:
- Trigger when P/E drops below 15x (historically cheap)
- Alert if PEG falls under 1.0 (growth at discount)
- Notify when FCF yield exceeds 8% (cash machine)
Safety Degradation Alerts:
- Warning if interest coverage drops below 3x
- Alert when current ratio falls under 1.2
- Notify if payout ratio exceeds 80% (dividend risk)
Quality Improvement Alerts:
- Celebrate when ROE crosses 20% threshold
- Alert on 3 consecutive quarters of margin expansion
- Notify when inventory turnover improves 15%+
StockAlert.pro continuously monitors these formulas across your entire portfolio, alerting you only when meaningful changes occur. Instead of daily spreadsheet maintenance, you receive actionable intelligence exactly when it matters.
The Formula-Driven Portfolio Strategy
Building a Formula-Based System
Portfolio Construction Rules:
Growth Sleeve (40% of portfolio):
- Revenue growth: 20%+ annually
- PEG ratio: Below 2.5
- ROE: 15%+ and increasing
- Current ratio: Above 2.0
- Debt-to-Equity: Below 0.5
Value Sleeve (40% of portfolio):
- P/E: Below sector median
- FCF Yield: Above 6%
- ROE: Above 12%
- Interest Coverage: Above 5x
- Payout Ratio: 30-60% (sustainable dividends)
Quality Sleeve (20% of portfolio):
- ROE: Consistently 20%+
- Net Margin: 15%+ and stable
- Debt-to-Equity: Below 0.3
- Revenue 5-year CAGR: 10%+
- No P/E limit (paying for quality)
Rebalancing Triggers:
- Sell growth if PEG exceeds 3.5
- Sell value if P/E exceeds sector average + 20%
- Sell quality if ROE drops below 15% for 2 quarters
- Sell any if interest coverage drops below 2.5x
Your Formula Mastery Action Plan
30-Day Formula Mastery Challenge
Week 1: Profitability Mastery
- Day 1-2: Calculate gross margin for 10 companies in one sector
- Day 3-4: Calculate ROE for those same 10 companies
- Day 5-7: Compare results, identify patterns, rank by profitability
Week 2: Valuation Expertise
- Day 8-9: Calculate P/E and PEG for your watchlist
- Day 10-11: Calculate EV/EBITDA for same companies
- Day 12-14: Create valuation matrix, identify bargains
Week 3: Safety Analysis
- Day 15-16: Calculate current ratio and quick ratio
- Day 17-18: Calculate debt-to-equity and interest coverage
- Day 19-21: Rank companies by financial safety
Week 4: Integrated Analysis
- Day 22-24: Perform complete 5-minute analysis on 5 new stocks
- Day 25-27: Build your formula-based portfolio model
- Day 28-30: Set up StockAlert.pro formula-based alerts
The Ultimate Truth About Financial Formulas
After analyzing thousands of stocks using these formulas over decades, here's what I've learned: Formulas don't predict the future—they illuminate the present with perfect clarity.
The market is messy, emotional, and often irrational in the short term. But over time, mathematical reality asserts itself. Companies with strong formulas outperform those with weak formulas with remarkable consistency. Not every time, not immediately, but overwhelmingly over periods that matter.
Mastering these formulas won't make you a perfect investor. You'll still make mistakes, miss opportunities, and occasionally lose money. But you'll make decisions based on data rather than hope, analysis rather than emotion, and mathematics rather than marketing.
That's not just an edge in investing—it's the edge. The difference between professional and amateur isn't talent or luck; it's systematic application of fundamental formulas that separate real value from clever storytelling.
Final Challenge: Your Formula Certification
Pick any public company—your current largest holding or one you're researching. Calculate every formula in this guide. Build a complete financial profile. Then ask yourself:
- Based purely on these numbers, would I buy this company today?
- What's the strongest metric? The weakest?
- How does it compare to the top 3 competitors?
- What's the trend—improving or deteriorating?
- At what price would the formulas say "buy"?
If you can answer these questions confidently using the formulas in this guide, you've graduated from casual investor to data-driven analyst. You now speak the language of professional investing.
The market rewards those who do their homework. These formulas are your homework assignments. Get calculating.
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