16 – M4 L1B 17 Fundamental Ratios V2

Many fundamental factors are different variations of the price to earnings ratio. Note that [inaudible] typically use the data measured as earnings per share divided by price instead of price divided by earnings. Why? Earnings could be zero or close to zero. So, the data using price divided by earnings may end up with numbers close to infinity or even null values. Using earnings divided by price helps to reduce these kinds of data issues. The book to price ratio may be a good alternative to earnings divided by price because earnings may be negative while book to price ratios remain positive as long as the company’s net asset value is positive. Other variations of fundamental ratios try to remove accounting choices from the metric by looking at direct cash flows instead of earnings. Example of these include cash flow, earnings before interest, tax depreciation, and amortization. You don’t need to dive into accounting for this lesson, but it helps to get a sense of how earnings are different from cash flow. Cash flow is the amount of cash flowing into and out of a company. The cash flow can be a more volatile metric than earnings, but it’s also more difficult for company executives to manipulate. Cash flow maybe more volatile due to large upfront capital costs such as buying expensive equipment. Accounting smooths out the earnings by spreading out the cost of these purchases over the lifetime of the asset. So, earning numbers are more smooth and less jumpy compared to cash flow. The earnings numbers come from the interpretations of accounting rules and there can be some judgment in applying these accounting rules. This is not the case with cash. With cash, it’s either there or it isn’t. Since accountants decide how to spread out the initial purchase over time, there is a human element in earnings that may add noise to the data. Whereas cash flows are a more direct measure of the state of the company’s finances.

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