Financial Metrics Glossary
Master the fundamental and advanced financial metrics used by Wall Street analysts to evaluate companies, assess risk, and identify investment opportunities.
Valuation Metrics
Valuation metrics help investors determine whether a stock is overvalued, undervalued, or fairly priced relative to its fundamentals. These are the most widely used metrics in equity research.
1. Price-to-Earnings Ratio (P/E)
The P/E ratio measures how much investors are willing to pay for each dollar of earnings. It's the most popular valuation metric on Wall Street.
- Market Price per Share:
- Current stock price in the market
- EPS (Earnings per Share):
- Net Income / Number of Outstanding Shares
Live Comparison: P/E Ratios by Industry Sector
Sector Analysis:
- High P/E (>30x): Tech/SaaS companies → Investors pay premium for high growth expectations
- Medium P/E (15-25x): Healthcare/Consumer goods → Balanced growth and stability
- Low P/E (<15x): Financials/Energy/Utilities → Cyclical or slow-growth industries
Investment Strategy:
- Value Investing: Look for P/E < industry average (potential undervaluation)
- Growth Investing: Accept high P/E if revenue growth >20% annually
- Relative Valuation: Compare P/E to sector peers, not just S&P 500 average
- PEG Ratio: P/E / Growth Rate → PEG < 1.0 = attractive for growth stocks
⚠ Warning: P/E is useless for unprofitable companies (negative earnings). Use P/S (Price-to-Sales) instead.
Scenario:
- Current Stock Price: $180
- Annual EPS: $6.00
- P/E Ratio = $180 / $6.00 = 30x
Interpretation:
Investors are paying $30 for every $1 of Apple's earnings. Compared to the S&P 500 average P/E of ~20x, Apple trades at a premium, suggesting high growth expectations.
P/E benchmarks vary by industry:
- Tech stocks: 25-40x (high growth)
- Financial services: 10-15x (cyclical)
- Utilities: 12-18x (stable, low growth)
- High-growth SaaS: 50-100x (future potential)
2. Price-to-Book Ratio (P/B)
The P/B ratio compares a company's market value to its book value (net assets). It's particularly useful for evaluating banks, real estate, and asset-heavy companies.
Or: P/B = Price per Share / Book Value per Share
- Book Value:
- Total Assets - Total Liabilities (Shareholders' Equity)
- Book Value per Share:
- Shareholders' Equity / Number of Outstanding Shares
Live Analysis: P/B Ratio vs ROE (Quality vs Valuation)
Quadrant Analysis:
- Top Right (High P/B, High ROE): Quality companies trading at premium → Microsoft, Apple (justified premium)
- Top Left (Low P/B, High ROE): Value opportunities → Hidden gems, undervalued quality stocks
- Bottom Right (High P/B, Low ROE): Overvalued → Avoid (paying too much for poor returns)
- Bottom Left (Low P/B, Low ROE): Value traps → Distressed companies, turnaround plays
Investment Strategy:
- Best Opportunities: Look for companies with ROE >15% trading at P/B <2.0 (top left quadrant)
- Quality at Any Price: ROE >25% justifies P/B up to 5-10x (exceptional companies)
- Red Flag: P/B >3.0 with ROE <10% = Bubble territory, avoid
💎 Pro Tip: Banks should trade at P/B 1.0-1.5x. Tech companies at P/B 5-15x is normal (intangible assets).
Data:
- Stock Price: $30
- Book Value per Share: $25
- P/B Ratio = $30 / $25 = 1.2x
Analysis:
BAC trades at 1.2x book value. A P/B < 1.0 could indicate undervaluation, while P/B > 3.0 suggests the market values intangibles (brand, customer base) highly.
3. Enterprise Value to EBITDA (EV/EBITDA)
EV/EBITDA is a comprehensive valuation metric used in M&A and corporate finance. It accounts for debt and is independent of capital structure.
Enterprise Value (EV) = Market Cap + Total Debt - Cash
- EBITDA:
- Earnings Before Interest, Taxes, Depreciation, and Amortization
- Why use EV?
- Represents the total cost to acquire a company (equity + debt - cash)
Live Comparison: EV/EBITDA Multiples Across Industries
Multiple Interpretation:
- Low EV/EBITDA (5-8x): Mature industries (retail, manufacturing) → Potential acquisition targets
- Medium (8-12x): Average market valuation → Fair value for stable businesses
- High (15-25x): High-growth sectors (tech, biotech) → Premium for innovation
- Very High (>25x): Either exceptional growth or overvaluation → Due diligence required
M&A Strategy:
- Acquisition Targets: Look for EV/EBITDA <8x in consolidating industries
- Fair Value: Compare to sector median ± 20% (accounts for company-specific factors)
- Synergy Justification: Acquirers pay 20-40% premium → Target EV/EBITDA typically 10-15x
🎯 Pro Tip: EV/EBITDA works better than P/E for comparing companies with different capital structures (debt levels).
Company Profile:
- Market Cap: $5 billion
- Total Debt: $1 billion
- Cash: $500 million
- EBITDA: $750 million
Calculation:
EV = $5B + $1B - $0.5B = $5.5B
EV/EBITDA = $5.5B / $0.75B = 7.3x
Benchmark: Tech companies typically trade at 10-15x EV/EBITDA, suggesting this could be an attractive acquisition target.
| Metric | Best For | Typical Range | Limitations |
|---|---|---|---|
| P/E Ratio | Profitable companies with stable earnings | 15-25x (market avg) | Useless for unprofitable companies |
| P/B Ratio | Banks, real estate, asset-heavy firms | 1-3x | Ignores intangible assets (brand, IP) |
| EV/EBITDA | M&A, comparing companies with different capital structures | 8-12x | Ignores capex requirements |
| P/S Ratio | High-growth, unprofitable companies (SaaS) | 2-10x | Doesn't account for profitability |
Profitability Metrics
Profitability metrics measure a company's ability to generate profit relative to revenue, assets, or equity. These are critical for assessing operational efficiency and management effectiveness.
1. Return on Equity (ROE)
ROE is Warren Buffett's favorite metric. It measures how effectively management uses shareholders' equity to generate profits.
- Net Income:
- Profit after all expenses, taxes, and interest
- Shareholders' Equity:
- Total Assets - Total Liabilities (book value)
Live Comparison: ROE Across Blue-Chip Companies
ROE Quality Tiers:
- Exceptional (>20%): World-class companies with durable competitive advantages (Apple, Microsoft, Visa)
- Good (15-20%): Above-average performers, solid investment candidates
- Average (10-15%): Acceptable but unexciting, scrutinize for improvement trends
- Poor (<10%): Red flag → Capital inefficiency, potential turnaround play or avoid
Investment Strategy:
- Quality Screening: Filter for ROE >15% sustained over 5+ years (consistency matters)
- Competitive Moat: High ROE (>25%) indicates pricing power, brand strength, or network effects
- Capital Allocation: Compare ROE to cost of equity (CAPM) → ROE should exceed cost by 5%+
⚠ Warning: High ROE from excessive leverage can be risky. Check Debt/Equity ratio!
Financials:
- Net Income: $72 billion
- Shareholders' Equity: $200 billion
- ROE = ($72B / $200B) × 100% = 36%
Interpretation:
Microsoft generates $0.36 in profit for every $1 of equity. ROE > 15% is excellent; Microsoft's 36% ROE indicates exceptional management and competitive advantages (moats).
The DuPont Formula decomposes ROE into three components:
ROE = (Net Income/Revenue) × (Revenue/Assets) × (Assets/Equity)
This reveals whether high ROE comes from operational efficiency, asset utilization, or leverage.
2. Profit Margins
Operating Margin = (Operating Income / Revenue) × 100%
Net Margin = (Net Income / Revenue) × 100%
Live Example: Profit Margin Evolution Over Time
Margin Interpretation:
- Expanding Margins: Operating leverage kicking in → Revenue growing faster than costs (bullish)
- Stable Margins: Mature business with pricing power, consistent operations
- Contracting Margins: Red flag → Increasing competition, rising costs, or pricing pressure
Margin Gap Analysis:
- Gross - Operating Margin: Large gap = high SG&A expenses (sales, marketing, R&D)
- Operating - Net Margin: Large gap = high interest/tax burden or non-operating losses
- Ideal Profile: All three margins expanding together = healthy growth with efficiency
🎯 Action Items:
- Buy when margins expand + revenue grows (double positive)
- Caution when margins contract for 3+ consecutive quarters
- Compare to industry peers (e.g., SaaS should have >70% gross margin)
| Company | Gross Margin | Operating Margin | Net Margin | Insight |
|---|---|---|---|---|
| Apple (Tech) | 43% | 30% | 25% | High margins = pricing power |
| Walmart (Retail) | 25% | 4% | 2.5% | Low margins = volume business |
| Google (SaaS) | 56% | 28% | 23% | Software = high gross margins |
| Ford (Auto) | 15% | 6% | 4% | Cyclical, capital-intensive |
Liquidity Metrics
Liquidity metrics assess a company's ability to meet short-term obligations without raising external capital. Critical for avoiding bankruptcy risk.
- Healthy Range:
- 1.5 - 3.0 (varies by industry)
- Interpretation:
- Ratio > 2.0 = Strong liquidity | Ratio < 1.0 = Liquidity crisis risk
- Why exclude inventory?
- Inventory may not convert to cash quickly in a crisis
- Conservative Measure:
- Quick Ratio > 1.0 is considered safe
Live Analysis: Current Ratio vs Quick Ratio
Ratio Interpretation:
- Strong Liquidity (Current >2.0, Quick >1.5): Can survive 12+ months of revenue loss
- Adequate (Current 1.5-2.0, Quick 1.0-1.5): Comfortable but monitor quarterly
- Warning (Current 1.0-1.5, Quick 0.5-1.0): Tight cash position, vulnerable to shocks
- Critical (Current <1.0, Quick <0.5): Imminent liquidity crisis, bankruptcy risk
Gap Analysis (Current - Quick Ratio):
- Small Gap (<0.5): Low inventory business (services, software) → Less liquidity risk
- Large Gap (>1.0): Inventory-heavy (retail, manufacturing) → Monitor inventory turnover
🚨 Red Flags:
- Declining trend in both ratios over 3+ quarters
- Quick Ratio <0.5 + rising short-term debt
- Current Ratio >4.0 may indicate inefficient capital use (hoarding cash)
Warning signs of impending liquidity problems:
- Current Ratio < 1.0 (liabilities exceed assets)
- Quick Ratio < 0.5 (severe cash shortage)
- Declining cash flow from operations
- Increasing reliance on short-term debt
- Days Sales Outstanding (DSO) rising rapidly
Leverage Metrics
Leverage metrics measure a company's debt burden and financial risk. High leverage amplifies returns in good times but increases bankruptcy risk in downturns.
- Conservative:
- D/E < 0.5 (low leverage)
- Moderate:
- D/E = 0.5 - 1.5
- Aggressive:
- D/E > 2.0 (high financial risk)
- Safe Zone:
- Ratio > 3.0 (can easily cover interest payments)
- Danger Zone:
- Ratio < 1.5 (financial distress risk)
Case Study: Tesla's Debt Reduction Journey (2018-2024)
D/E Ratio Analysis:
- Conservative (<0.5): Fortress balance sheet → Survives recessions easily (Berkshire Hathaway)
- Moderate (0.5-1.5): Optimal leverage → Amplifies ROE without excessive risk
- Aggressive (1.5-3.0): High risk/reward → Works in bull markets, dangerous in recessions
- Distress (>3.0): Bankruptcy risk → Avoid unless turnaround specialist
Interest Coverage Insights:
- >10x: Debt is negligible, company can take on more if needed
- 3-10x: Comfortable debt service, sustainable
- 1.5-3x: Tight margins, vulnerable to earnings decline
- <1.5x: Cannot cover interest from operations → Refinancing or asset sale needed
🎯 Investment Strategy:
- Look for D/E improving trend (deleveraging = bullish)
- Accept high D/E (>2.0) only if Interest Coverage >5x and stable cash flows
- Avoid companies with D/E >2.0 + negative FCF (death spiral risk)
2018 (High Risk Period):
- Total Debt: $12 billion
- Shareholders' Equity: $5 billion
- D/E Ratio = 12/5 = 2.4 (Highly leveraged)
- Interest Coverage < 1.0 (couldn't cover interest from operations)
2023 (Improved):
- Total Debt: $5 billion
- Shareholders' Equity: $60 billion
- D/E Ratio = 5/60 = 0.08 (Very conservative)
- Interest Coverage > 20x (strong financial health)
Efficiency Metrics
Efficiency metrics measure how well a company utilizes its assets to generate revenue. Key for operational excellence analysis.
- Interpretation:
- Higher ratio = More efficient asset utilization
- Industry Variation:
- Retail (2-3x) vs. Capital-intensive industries (0.5-1x)
Days Inventory Outstanding = 365 / Inventory Turnover
Live Comparison: Inventory Turnover Across Industries
Turnover Interpretation:
- High Turnover (>10x): Fast-moving goods, minimal waste, strong demand (Amazon, Tesla)
- Medium (5-10x): Standard retail/consumer goods efficiency
- Low (<5x): Slow-moving inventory, luxury goods, or long production cycles (Boeing, jewelry)
Days Inventory Analysis:
- <30 days: Just-in-time inventory, build-to-order model (Tesla, Dell)
- 30-90 days: Healthy balance between stock availability and efficiency
- >90 days: Potential obsolescence risk, overstocking, or weak demand
🎯 Investment Insights:
- Rising turnover = operational improvement (bullish)
- Falling turnover + rising inventory = demand problem (bearish)
- Compare to industry: Walmart (8.5x) vs. luxury brands (2-3x is normal)
| Company | Inventory Turnover | Days Inventory | Insight |
|---|---|---|---|
| Amazon | 8.5x | 43 days | Fast-moving inventory |
| Tesla | 12x | 30 days | Build-to-order model |
| Boeing | 1.2x | 304 days | Long production cycles |
Growth Metrics
Growth metrics track a company's revenue, earnings, and cash flow expansion over time. Critical for identifying high-growth opportunities.
- n:
- Number of years
- Use Case:
- Smooths out volatile year-over-year growth
Live Example: Revenue Growth Trajectory (CAGR Analysis)
Growth Rate Tiers:
- Hyper-Growth (>40% CAGR): Early-stage disruptors, high risk/reward (crypto, SaaS startups)
- High Growth (20-40% CAGR): Proven scalers, institutional favorites (FAANG during 2010s)
- Moderate Growth (10-20% CAGR): Solid performers, sustainable long-term
- Slow Growth (<10% CAGR): Mature companies, dividend focus (utilities, consumer staples)
Quality Checks:
- Organic vs Acquisition Growth: Organic is sustainable, M&A growth needs integration success
- Revenue + Margin Expansion: Both growing = healthy scaling (operating leverage)
- Consistency: Prefer steady 20% CAGR over volatile 10-30% swings
🎯 Valuation Context:
- 40% CAGR company can justify P/E 50-80x (PEG ratio <2.0)
- 20% CAGR → P/E 30-40x is fair
- 10% CAGR → P/E should be <20x
Data:
- 2018 Revenue: $15.8 billion
- 2023 Revenue: $33.7 billion
- Period: 5 years
Calculation:
Netflix grew revenue at a 16.3% compound rate over 5 years, significantly outpacing the media industry average of ~5%.
Discounted Cash Flow (DCF) Valuation
DCF is the gold standard of valuation used by investment banks and private equity firms. It values a company based on its ability to generate future cash flows.
- FCF (Free Cash Flow):
- Operating Cash Flow - Capital Expenditures
- WACC (Weighted Average Cost of Capital):
- Discount rate reflecting the company's cost of financing
- Terminal Value:
- Present value of all cash flows beyond the forecast period
- E/V:
- Equity as % of total value
- Re:
- Cost of equity (from CAPM)
- D/V:
- Debt as % of total value
- Rd:
- Cost of debt (interest rate)
- Tc:
- Corporate tax rate
Live Example: DCF Valuation Breakdown (Waterfall Chart)
DCF Component Analysis:
- PV of FCF (Years 1-5): Typically 20-40% of total value → Near-term cash flows
- Terminal Value: Usually 60-80% of total → Long-term assumptions critical
- Debt Adjustment: Subtract net debt to get equity value
Key Assumptions to Validate:
- Revenue Growth: Should decline gradually to terminal growth (2-3%) → Law of large numbers
- FCF Margin: Cross-check against industry benchmarks (e.g., SaaS 20-30%)
- WACC: 8-12% for most companies (use CAPM for cost of equity)
- Terminal Growth: Never exceed GDP growth (~2-3% in developed markets)
🎯 Sensitivity Analysis:
- Run scenarios with WACC ±1% and terminal growth ±0.5%
- If valuation swings >30% → Model too sensitive, refine assumptions
- Compare to market cap: >30% difference suggests mispricing or bad assumptions
DCF Sensitivity Analysis: Valuation Impact of Key Assumptions
Assumption Impact Ranking:
- Terminal Growth (+1%): Most sensitive → Small change = big impact on valuation
- WACC (-0.5%): High impact → Lower discount rate = higher present value
- FCF Margin (+5%): Moderate impact → Operational improvements matter
- Revenue Growth (+10%): Least sensitive → Growth already priced in baseline
Investment Decision Framework:
- Base Case ($3,659M): Use conservative assumptions → Fair value estimate
- Upside Scenarios: If 2-3 positive assumptions hit → $4,200-4,500M valuation
- Downside Scenarios: If assumptions miss → $3,000-3,200M valuation
- Margin of Safety: Buy at >20% discount to base case ($2,900M or less)
💡 Pro Tip: Never rely on a single DCF. Run 3 scenarios (bull/base/bear) and probability-weight them!
Step 1: Project Free Cash Flows
| Year | Revenue | FCF | PV of FCF |
|---|---|---|---|
| 1 | $1,000M | $150M | $136M |
| 2 | $1,200M | $180M | $149M |
| 3 | $1,440M | $216M | $162M |
| 4 | $1,728M | $259M | $177M |
| 5 | $2,074M | $311M | $193M |
Step 2: Calculate Terminal Value
= $311M × 1.03 / (0.10 - 0.03) = $4,576M
PV of Terminal Value = $4,576M / (1.10)^5 = $2,842M
Step 3: Sum to Enterprise Value
= ($136 + $149 + $162 + $177 + $193) + $2,842
= $3,659M
Step 4: Calculate Equity Value
= $3,659M - $500M + $200M = $3,359M
Price per Share = $3,359M / 100M shares = $33.59
DCF valuations are highly sensitive to assumptions:
- Growth Rate: 1% change can alter valuation by 20-30%
- WACC: 0.5% change = 15% valuation swing
- Terminal Value: Often represents 60-80% of total value
Best Practice: Run sensitivity analysis with multiple scenarios (base, bull, bear cases).