Web : http://pages.stern.nyu.

edu/~adamodar/

Accounts - Glossary
Abnormal return (excess return): Difference between the actual returns on an
investment and the expected return on that investment, given market returns and
investment's risk..
Accelerated depreciation: A depreciation method where more of the asset is written off
in earlier years and less in later years, over its lifetime, to reflect the aging of the asset.
Accounting beta: Beta estimated using accounting earnings for a firm and accounting
earnings for the market, rather than stock prices.
Accrual accounting: Accounting approach, where the revenue from selling a good or
service is recognized in the period in which the good is sold or the service is performed
(in whole or substantially). A corresponding effort is made on the expense side to match
expenses to revenues.
Acquisition premium: Difference between the price paid to acquire a firm and the
market price prior to the acquisition.
Acquisition price: Price that will be paid by an acquiring firm for each of the target
firmճ shares.
Adjustable rate preferred stock: Preferred stock where the preferred dividend rate is
pegged to an external index, such as the treasury bond rate.
Agency costs: Costs arising from conflicts of interest between two stakeholders;
examples would be managers & stockholders as well as stockholders & bondholders.
Allocation: Process of distributing a cost that cannot be directly traced to a revenue
center across different units, projects or divisions.
American options: An option that can be exercised any time until maturity.
Amortizable life: A period of time over which an intangible asset is written off.
Annual percentage rate (APR): A rate that has to be cited with loans and mortgages in
the United States. The rate incorporates an amortization of any fixed charges that have to
be paid up front for the initiation of the loan.
Annuity: A stream of constant cash flows that occur at regular intervals for a fixed
period of time.
Arbitrage position: A riskless position that yields a return that exceeds the riskfree rate.
Arbitrage principle: Assets that have identical cash flows cannot sell at different prices.
Asset beta: The beta of the assets of investments of a firm, prior to financial leverage.
Can be computed from the regression beta (top-down) or by taking a weighted average of
the betas of the different businesses (bottom-up).
Asset-backed borrowing: Bonds or debt secured by assets of any type. Mortgage bonds
and collateral bonds are special cases.
Assets-in-place: The existing investments of a firm.
Bad debts: Portion of loans that cannot be collected (if you are the lender) or will not be
paid (if you are the borrower).

1
Balance sheet: A summary of the assets owned by a firm, the book value of these assets
and the mix of financing, debt and equity, used to finance these assets at a point in time.
Balloon payment bonds: Bonds where no principal repayment is made during the life of
the bond but the entire principal is repaid at maturity.
Bankrupt: The state in which a firm finds itself if it is unable to meet its contractual
commitments.
Barrier options: An option where the payoff on, and the life of, the option are a function
of whether the underlying asset price reaches a certain level during a specified period.
Baumol model: Model for estimating an optimal cash balance, given the cost of selling
securities and the interest rate that can be earned on marketable securities, for firms with
certain cash inflows and outflows.
Best efforts guarantee: Underwriting agreement on a security issue where the
investment banker does not guarantee a fixed offering price.
Beta: A measure of the exposure of an asset to risk that cannot be diversified away (also
called market risk). It is standardized around 1. (Average = 1, Above average risk >1)
Binomial option pricing model: Option pricing model based upon the assumption that
stock prices can move to only one of two levels at each point in time.
Book value: Accounting estimate of the value of an asset or liability, usually from the
balance sheet of the firm.
Bottom-up betas: Beta computed by taking a weighted average of the betas of the
businesses that a firm is in. These betas, in turn, are estimated by looking at firms that
operate only or primarily in each of these businesses.
Building the book: Process of polling institutional investors prior to pricing an initial
offering, to gauge the extent of the demand for an issue.
Call market: A market where an auctioneer (or a market maker) holds an auction at
certain times in the trading day and sets a market-clearing price, based upon the orders
grouped together at that time.
Callable bonds (debt): Debt (bonds), where the borrower has the right to pay the bonds
back at any time. The option to pay back will generally be used if interest rates decrease.
Cap: The maximum interest rate on a floating rate bond.
Capital expenses: Expenses that are expected to generate benefits over multiple periods.
Accounting rules generally require that these expenses be depreciated or amortized over
the multiple periods.
Capital lease: The lessee assumes some of the risks of ownership and enjoys some of
the benefits. Consequently, the lease, when signed, is recognized both as an asset and as a
liability (for the lease payments) on the balance sheet.
Capital rationing: Situation that occurs when a firm is unable to invest in projects that
earn returns greater than the hurdle rates because it has limited capital (either because of
internal or external constraints).
Capped call: A call where the payoff is restricted on the upside. If the price rises above
this level, the call owner does not get any additional payoff.
Cash flow to equity investors: Cash flows generated by the asset after all expenses and
taxes, and also after payments due on the debt.

2
Cash flow to the firm: Cash flows generated by the asset for both the equity investor and
the lender. This cash flow is before debt payments but after operating expenses and taxes.
Cash slack: Combination of excess cash and limited project opportunities in a firm.
Cashflow return on investment (CFROI): Internal rate of return on the existing
investments of the firm, estimated in real terms, using the original investment in the
assets, their remaining life and expected cash flows.
Catastrophe bond: A bond that allows for the suspension of coupon payments and/or
the reduction of principal, in the event of a specified catastrophe.
Certainty equivalent (cash flow): A guaranteed cash flow that you would agree to
accept in exchange for a much larger and riskier cash flow.
Chapter 11: Legal process governing bankruptcy proceedings.
Clientele effect: Clustering of stockholders in companies with dividend policies that
match their preferences for dividends.
Collateral bond: Bond secured with marketable securities
Combination leases: A lease that shares characteristics with both operating and capital
leases.
Commercial paper: Short term notes issued by corporations to raise funds.
Commodity bond: A bond whose coupon rate is tied to commodity prices.
Competitive risk: Risk that the cash flows on projects will vary from expectations
because of actions taken by competitors.
Compound options: An option on an option.
Compounding: The process of converting cash flows today into cash flows in the future.
Concentration banking: System where firms pick banks around the country to process
checks, allowing for the faster clearing of checks
Consol bond: A bond with a fixed coupon rate that has no maturity (infinite life).
Consolidation (in mergers): A combination of two firms where a new firm is created
after the merger, and both the acquiring firm and target firm stockholders receive stock in
this firm.
Consolidation (in accounting statements): The accounting approach used to show the
income from ownership of securities in another firm, where it is a majority, active
investment. The balance sheets of the two are merged and presented as one balance sheet.
The income statements, likewise, represent the combined income statements of the two
firms.
Contingent liabilities: Potential liabilities that will be incurred under certain
contingencies, as is the case, for instance, when a firm is the defendant in a lawsuit.
Contingent value rights: Securities where holders receive the right to sell the shares in
the firm at a fixed price in the future; it is a long term put option on the equity of the firm.
Continuing value: present value of the expected cash flows from continuing an existing
investment through the end of its life.
Continuous market: A market where prices are determined through the trading day as
buyers and sellers submit their orders.

3
Continuous price process: Price process where price changes becoming infinitesimally
small as time periods become smaller.
Conversion premium: Excess of convertible bond market value over its conversion
value.
Convertible bond: A bond that can be converted into a pre-determined number of shares
of the common stock, at the discretion of the bondholder
conversion ratio (in convertible bond): Number of shares of stock for which a
convertible bond may be exchanged.
Convertible preferred stock:: Preferred stock that can be converted into common
equity, at the discretion of the preferred stockholder.
Cost of capital: Weighted average of the costs of the different sources of financing used
by a firm.
Cost of debt (pre-tax): Interest rate, including a default spread, that a borrower has to
pay to borrow money.
Cost of debt (after-tax): Interest rate, including a default spread, that a borrower has to
pay to borrow money, adjusted for the tax deductibility of interest.
Cost of equity: The rate of return that equity investors in a firm expect to make on their
investment, given its riskiness.
Cumulative abnormal (excess) returns (cars): Difference between the actual return on
an investment and the expected return, given market returns and stock's risk, cumulated
over a period surrounding an event (such as an earnings announcement).
Current assets: Short-term assets of the firm, including inventory of both raw material
and finished goods, receivables (summarizing moneys owed to the firm) and cash.
Current PE: Ratio of price per share to earnings per share in most recent financial year.
Debentures: Unsecured bonds issued by firms with a maturity greater than 15 years.
Debt Exchangeable for Common Stock (decs).: Debt that can be exchanged for
common stock, with the conversion rate depending upon the stock price.
Debt: Any financing vehicle that has a contractual claim on the cash flows and assets of
the firm, creates tax deductible payments, has a fixed life, and has priority claims on the
cash flows in both operating periods and in bankruptcy.
Default risk: Risk that a promised cash flow on a bond or loan will not be delivered.
Default spread: Premium over the riskless rate that you would pay (if you were a
borrower) because of default risk.
Deferred tax asset: Asset created when companies pay more in taxes than the taxes they
report in the financial statements.
Depreciation: Accounting adjustments to the book value of an asset for the aging and
subsequent loss of earning power on it. Applies when you have a capital expenditure.
Direct cost of bankruptcy: Costs include the legal and administrative costs, once a firm
declares bankruptcy, as well as the present value effects of delays in paying out the cash
flows.
Cost of bankruptcy (direct): Costs include the legal and administrative costs, once a
firm declares bankruptcy, as well as the present value effects of delays in paying out the
cash flows.

4
Disbursement float: Lag between when a check is written and the time it is cleared,
when the firm is writing the check.
Discount rate: the rate used to move cash flows from the future to the present, in
discounting, or from the present to the future, in compounding.
Discounting: the process of converting cash flows in the future to cash flows today.
Divestiture value: Value of an asset to the highest potential bidder for it.
Divestiture: Sale of asset, assets or division of a firm to third party.
Dividend capture (arbitrage): Strategy of buying stock before the ex-dividend day,
selling it after it goes ex-dividend and collecting the dividend.
Dividend declaration date: Date on which the board of directors declares the dollar
dividend that will be paid for that quarter (or period).
Dividend payment date: Date on which dividends are paid to stockholders.
Dividend payout ratio: Ratio of dividends to net income (or dividends per share to
earnings per share).
Dividend yield: Ratio of dividends, usually annualized, to current stock price.
Down-and-out option: A call option that ceases to exist if the underlying asset rises
above a certain price.
Dual currency bond: Bond with some cash flows (eg. Coupons) in one currency and
other cash flows (eg. Principal) in another.
Duration: Weighted maturity of all the cash flows on an asset or liability.
Economic exposure: Effect of exchange rate changes on the value of a firm with
exposure to foreign currencies.
Economic order quantity (EOQ): The order quantity that minimizes the total costs of
new orders and the carrying cost of inventory.
Economic Value Added (EVA): Measure of dollar surplus value created by a firm or
project. It is defined to be the difference between the return on capital and the cost of
capital multiplied by the capital invested.
Efficient Frontier: The line connecting efficient portfolios, i.e. Portfolios that yield the
highest expected return for each level of risk (standard deviation).
Enterprise value: Market value of debt and equity of a firm, net of cash.
Equity approach: The accounting approach used to show the income from ownership of
securities in another firm, where it is a minority, active investment. A proportional share
(based upon ownership proportion) of the net income and losses made by the firm in
which the investment was made, is used to adjust the acquisition cost.
Equity carve out (ECO): Action where a firm separates out assets or a division, creates
shares with claims on these assets, and sells them to the public. Firm generally retains
control of the carved out asset.
Equity risk: Measure of deviation of actual cash flows from expected cash flows.
Equity: Any financing vehicle that has a residual claim on the firm, does not create a tax
advantage from its payments, has an infinite life, does not have priority in bankruptcy,
and provides management control to the owner.

5
Eurobonds: Bonds issued in the local currency but offered in foreign markets.
Eurodollar and Euroyen bonds are examples.
Eurodollar bonds: Bonds denominated in U.S. dollars and offered to investors globally.
European options: An option that can be exercised only at maturity.
Euroyen bonds: Bonds denominated in Japanese Yen and offered to investors globally.
Excess return (abnormal return): Difference between the actual returns on an
investment and the expected return, given market returns and investment's risk.
Ex-dividend date: Date by which investors have to have bought the stock in order to
receive the dividend
Exercise Price (Strike Price): Price at which the underlying asset in an option can be
bought (if it is a call) or sold (if it is a put).
Exit value: Estimated value of a private firm in a year in which the owners plan to sell it
to someone else or to take it public.
Ex-rights price: Stock price without the rights attached to the stock, in a rights offering.
External financing: Cash flows raised outside the firm whether from private sources or
from financial markets.
Factor beta: A measure of the exposure of an asset to a specified macroeconomic factor
(such as inflation or interest rates) or an unspecified market factor.
FIFO: An inventory valuation method, where the cost of goods sold is based upon the
cost of material bought earliest in the period, while the cost of inventory is based upon
the cost of material bought later in the year.
Financing expenses: Expenses arising from the non-equity financing used to raise capital
for the business
Firm: any business large or small, privately run or publicly traded, and engaged in any
kind of operation - manufacturing, retail or service.
Firm-specific risk: Risk that affects one or a few firms, and is thus risk that can be
diversified away in a portfolio.
Fixed (exchange) rates: Exchange rate set and backed up by a government, rather than by
demand and supply.
Fixed assets: Long term and tangible assets of the firm, such as plant, equipment, land
and buildings.
Fixed-rate bond: Bond with a coupon rate that is fixed for the life of the bond.
Float: Lag between when the check is written and the time it is cleared.
Floating (exchange) rates: Exchange rates determined by demand and supply for the
currency, and thus change over time.
Floating rate bond: Bond with a coupon rate that is reset each period, depending upon a
specified market interest rate (prime or LIBOR).
Floor: The minimum interest rate on a floating rate bond.
Forward contracts: A contract to buy or sell an asset, security or currency in the future
at a fixed price (specified at the time of the contract)
Forward PE: Ratio of price per share to expected earnings per share in next financial
year.

6
Forward price (rate): The price or rate quoted in a forward contract.
Free cash flow to equity: cash left over after operating expenses, net debt payments and
reinvestments.
Free cash flow to the firm: Cash flow left over after operating expenses, taxes and
reinvestment needs, but before any debt payments (interest or principal payments).
Free cash flows (Jensen): Cash flows from operations over which managers have
discretionary spending power.
Futures contract: Like a forward contract, it is an agreement to buy or sell an underlying
asset at a specified time in the future. However, it differs from a forward because it is
usually traded, requires daily settlement of differences and has no default risk.
Golden parachute: A provision in an employment contract that allows for the payment
of a lump-sum or cash flows over a period, if the manager covered by the contract loses
his or her job in a takeover.
Goodwill: The difference between the market value of an acquired firm and the book
value of its assets; arises only when purchase accounting is used in an acquisition.
Gordon growth model: Stable-growth dividend discount model, where the value of a
stock is the present value of expected dividends, growing at a constant rate forever.
Greenmail: Buying out the existing stake of a hostile acquirer in the firm, generally at a
price much greater than the price paid by the acquirer. In return, the acquirer usually
agrees not to go through with the takeover or buy additional stock in the firm for a period
of time (standstill agreement).
Growing annuity: A cash flow that occurs at regular interval and grows at a constant
rate for a specified period of time.
Growing perpetuity: A cash flow that is expected to grow at a constant rate forever.
Growth assets: Investments yet to be made by the firm; often markets will incorporate
their expectation of the value of these assets into the market value.
Historical (risk) premium: Difference between returns on risky investments (usually
stocks) and riskless investments (usually government securities) over a specified past
time period.
Historical cost: The original price paid for an asset, when acquired, adjusted upwards for
improvements made to the asset since purchase and downwards for the loss in value
associated with the aging of the asset
Holder-of-record date: Date on which company closes its stock transfer books and
makes up a list of the shareholders.
Hurdle rate: a minimum acceptable rate of return on projects; used to determine whether
to invest in a project or not.
Hybrid securities: Securities that share some characteristics with debt and some with
equity. Examples would be preferred stock and convertible debt.
Implied premium: The premium estimated based upon the current level of stock prices
and expected cash flows from buying stocks. The internal rate of return that would make
the present value of the cash flows equal to today's stock prices is the expected return on
equity. Subtracting out the riskless rate yields the implied premium.

7
Income bonds: Bond on which interest payments are due only if the firm has positive
earnings.
Income statement: A statement which provides information on the revenues and
expenses of the firm, and the resulting income made by the firm, during a period.
Incremental cash flows: Cash flows that arise as a consequence of a new investment. It
is the difference between the cash flow a firm would have had without the new
investment and the cash flow with the new investment.
Indirect costs of bankruptcy: Costs associated with the perception that a firm may go
bankrupt - lost sales, drop in employee morale, tighter supplier creditɮ
Inflation rate: Change in purchasing power in a currency from period to period.
Inflation-indexed treasury bond: A government bond that guarantees a real interest
rate, rather than a nominal rate.
In-process R&D: Portion of an acquired firm's value that is attributed to past research.
This amount is usually written off right after the acquisition.
Intangible assets: Assets that do not have a physical presence but have value (either
because they generate cash or can be sold). Examples would include assets like patents
and trademarks as well as uniquely accounting assets such as goodwill that arise because
of acquisitions made by the firm
Interest rate parity: Equation that relates the differential between forward and spot
rates to interest rates in the domestic and foreign market.
Internal equity: Cash flows generated by the existing assets of a firm that are reinvested
back into the firm.
Internal rate of return (IRR): Discount rate that makes the net present value zero. It
can be considered a time-weighted, cash flow, rate of return on an investment.
International Fisher Effect: Specifies the relationship between changes in exchange
rates and differences in nominal interest rates in two countries.
Jump price proces: Price process where price changes stay large even as the period gets
shorter.
Knockout option: An option that ceases to exist if the underlying asset reaches a certain
price.
Kurtosis:: Measure of the likelihood of large jumps in a distribution, captured in the tails
of the distribution.
Leveraged buyout: An acquisition of a firm by its own managers or a private entity,
financed primarily with debt.
Leveraged recapitalization: Using new debt to repurchase equity and increasing debt
ratio substantially in the process.
Levered beta: Beta of a firm, reflecting its financial leverage. This will change as
leverage changes.
LIFO reserve: Difference in inventory valuation between FIFO and LIFO. Firms that
choose the LIFO approach to value inventories have to specify in a this difference.
LIFO: An inventory valuation method where the cost of goods sold is based upon the
cost of material bought towards the end of the period, resulting in inventory costs that
closely approximate current costs.

8
Line of credit: A financing arrangement, under which the firm can draw on only if it
needs financing, up to the agreed limit.
Liquidating dividends: Dividends in excess of the retained earnings of a firm. This is
viewed as return of capital in the firm and taxed differently.
Liquidation value: net cash flow that the firm will receive from selling an asset today.
Lockbox system: System where customer checks are directed to a post office box, rather
than to the firm
Major bracket investment bankers: Investment bankers in the top tier, based upon
reputation and national focus.
Majority active investment: Categorization of ownership of securities by one firm in
another firm are treated, if the securities represent more than 50% of the overall
ownership of that firm.
Management buyouts: An acquisition of a publicly traded firm by its own managers.
Marginal investor: The investor or investors most likely to be involved in the next trade
on the securities issued by a firm. Not necessarily the largest investor in the firm.
Marginal return on equity (capital): Measures quality of marginal investments, rather
than average investments. Computed as the change in income (net income or operating
income) divided by the change in equity or capital invested.
Marginal tax rate: Tax rate on the last dollar of income (or the next dollar of income).
Usually determined by the tax codes.
Market capitalization (market cap): Market value of equity in a firm.
Market conversion value: Current market value of the shares for which a convertible
bond can be exchanged.
Market efficiency: A measure of how much the price of an asset deviates from a firmճ
true value. The smaller and less persistent the deviations are, the more efficient a market
is.
Market risk: Risk that affects many or all investments in a market. This risk cannot be
diversified away in a portfolio.
Market value: Estimate of how much an asset would be worth if sold in the market
today. If the asset is a traded asset, this is obtained by looking at the last traded price.
Markowitz portfolios: The set of portfolios, composed entirely of risky assets, that yield
the highest expected returns for each level of risk (standard deviation).
Merger: A combination of two firms where the boards of directors of two firms agree to
combine and seek stockholder approval for the combination. In most cases, at least 50%
of the shareholders of the target and the bidding firm have to agree to the merger. The
target firm ceases to exist and becomes part of the acquiring firm.
Mezzanine bracket: Smaller investment banks that operate nationally.
Miller-Orr model: Model for estimating an optimal cash balance, given the cost of
selling securities and the interest rate that can be earned on marketable securities, for
firms with uncertain cash inflows and outflows.
Minority interest: The share of the firm that is owned by other investors, when one firm
owns a majority, active interest in another firm (more than 50%). The minority interest is

9
shown on the liability side of the balance sheet. Shows up only in the event of
consolidation.
Minority, active investment: Categorization of ownership of securities by one firm in
another firm are treated, if the securities represent between 20% and 50% of the overall
ownership of that firm. Usually get accounted for using the equity approach.
Modified internal rate of return (MIRR): Internal rate of return estimated with the
assumption that intermediate cash flows are reinvested at the cost of equity or capital
instead of the internal rate of return.
Mortgage bond: A bond secured by real property, such as land or buildings.
Mutually exclusive (projects): A set of projects where only one of the set can be
accepted by a firm.
Equivalent annuities: Annuity equivalent of the NPV of a multi-year project.
Near-cash investments: Investments that earn a market return, with little or no risk, and
can be quickly converted into cash.
Negative pledge clause: Clause in a bond issue that specifies that the bond is backed
only by the earning power of the firm, rather than specific assets.
Net debt payments: Difference between debt repaid and new debt issued by a firm
during a period.
Net float: Difference between the disbursement and processing float.
Net lease: A capital lease where the lessor is not obligated to pay insurance and taxes on
the asset, leaving these obligations up to the lessee; the lessee consequently reduces the
lease payments.
Net operating losses (nols): Accumulated losses over time that can be used to offset
income and save taxes in future periods.
Net present value (NPV): Sum of the present values of all of the cash flows on an
investment, netted against the initial investment.
Net present value profile: A graph that records the net present value as the discount rate
changes.
Nominal cash flow: A cash flow in nominal terms, or an expected cash flow that
includes the effects of inflation (higher prices for both inputs and output).
Nominal interest rate: Interest rate on a bond that incorporates expected inflation.
Non-cash working capital: Difference between non-cash current assets and non-debt
current liabilities.
Notes: Unsecured bonds issued by firms with maturity less than 15 years.
Offering price: Price of a stock at the initial public offering.
Open market repurchase: Stock repurchase where firms buy shares in securities
markets at the prevailing market price, and do not have to offer the premiums required for
tender offers.
Operating expenses: Expenses that provide benefits only for the current period
Operating exposure: Economic exposure that measures the effects of exchange rate
changes on expected future cash flows and discount rates, and, thus, on total value.
Operating lease: The lessor (or owner of the asset) transfers only the right to use the
property to the lessee. At the end of the lease period, the lessee returns the property to the

10
lessor. The lease expense is treated as an operating expense in the income statement and
the lease does not affect the balance sheet.
Operating leverage: A measure of the proportion of the costs that are fixed costs; the
higher the proportion the greater the operating leverage.
Opportunity costs: Costs associated with the use of resources that a firm may already
own.
Option delta: Number of units of the underlying asset that are needed to create the
replicating portfolio for an option.
Option: Right to buy or sell an underlying asset at a fixed price sometime during the
option's life (American option) or at the end of the option life (European option).
Original-issue deep discount bond: Bond with a coupon rate that is much lower than
the market interest rate at the time of the issue. This bond will be priced well below par.
Payback: Period of time over which the initial investment on a project will be recovered.
PEG ratio: Ratio of PE ratio to expected growth rate in earnings.
Perpetuity: A stream of constant cash flows that occur at regular intervals forever.
Poison pills: Securities, the rights or cash flows on which are triggered by hostile
takeovers. The objective is to make it difficult and costly to acquire control
Pooling accounting: Accounting approach for acquisitions where the book values of the
two firm involved in the acquisition are added up, and the market value of the acquisition
is not shown on the balance sheet.
Preferred stock: Security that pays a fixed dividend, which is usually not tax deductible,
and has an infinite life; usually has no or limited voting rights;
Preferred stock: Security which a fixed dollar dividend that is usually not tax deductible
to the firm; if the firm does not have the cash to pay the dividend, the dividend is
cumulated and paid in a period when there are sufficient earnings.
Price/book value: Ratio of price per share to book value of equity per share.
Price/earnings ratio (PE): Ratio of price per share to earnings per share.
Price/sales ratio (PS): Ratio of price per share to sales per share.
Principal exchange linked bonds (perls): Bonds where coupons and principal are
payable in US dollars, but the amount of the payment is determined by the exchange rate
between the US dollar and a foreign currency.
Private equity: Equity provided by private investors to companies, often with the intent of
taking the company from public to private status.
Private placement: An arrangement where securities are sold directly to one or a few
investors.
Privately negotiated repurchases: Stock repurchase negotiated with a stockholder who
owns a substantial percentage of the shares.
Probit: Statistical technique used to estimate probability of an event occurring.
Processing float: Lag between when the check is written and the time it is cleared, when
the customer is writing the check to the firm.
Product cannibalization: The effect that the introduction of a new product may have on
a firmճ existing product sales.

11
Profitability index: Ratio of net present value to initial investment in a project. Often
used when a firm faces capital rationing.
Project risk: Risk that affects the cash flows of a project will differ from expectations,
due to estimation errors or unanticipated events.
Purchase accounting: Accounting approach for acquisitions where the market value
paid for the acquired firm is shown on the balance sheet, and goodwill, which is the
difference between the book value and market value of the acquired firm, is shown as an
asset.
Purchase of assets: An action where one firm acquires the assets of another, though a
formal vote by the shareholders of the firm being acquired is still needed.
Purchasing power parity: Equation that relates changes in exchange rates to differences
in inflation. Based upon the assumption that a specific basket of goods should sell for the
same price across different countries
Pure play: Beta or other input estimated for a project by looking at the betas of firms that
are involved only or primarily in similar investments.
Put-call parity: Arbitrage relationship governing the prices of a call and put option, with
the same strike price, same exercise price and on the same underlying asset.
Puttable bonds: Debt (bonds), where bond buyers are allowed to put their bonds back to
the firm and receive face value, in the event of an occurrence like a leveraged buyout.
Rainbow options: An option that is exposed to more than one type of uncertainty.
Real cash flow: A cash flow that is corrected for the loss of buying power over time,
associated with inflation.
Real interest rate: Interest rate on a bond after taking out the expected inflation
component.
Real interest rate: The compensation, in real goods, that has to be offered to get lenders
to postpone consumption and allow you to use their savings.
Nominal interest rate: The compensation that has to be offered to lenders to induce
them to lend you money; the nominal component captures expected inflation.
Real options: An option on a real asset, as opposed to a financial asset.
Recapitalization: Changing financing mix by using new equity to retire debt or new debt
to reduce equity.
Red herring: Preliminary prospectus issued by a firm going public, while the registration
is being reviewed by the SEC.
Regular dividend: Dividend paid at regular intervals to stockholders.
Reinvestment rate: Proportion of after-tax operating income reinvested back into the
firm.
Replicating portfolio: A portfolio of the underlying asset and the riskless asset that has
the same cash flows as an option.
Repo rate: Implied interest rate in a repurchase agreement, calculated based upon the
difference between the price at which a security is bought and the price at which it will be
sold back.
Repurchase agreement (repo): The sale of a security, with an agreement that the
security will be bought back at a specified price at the end of the agreement period

12
Repurchase tender offer: Stock repurchase where firm specifies a price at which it will
buy back shares, the number of shares it intends to repurchase, and the period of time for
which it will keep the offer open.
Reverse repurchase agreement (reverse repo): The buying of a security, with an
agreement that the security will be soldback at a specified price at the end of the
agreement period.
Rights offering: Offering where existing investors in the firm are given the right to buy
additional shares, in proportion to their current holdings, at a price generally much lower
than the current market price (subscription price).
Rights-on price: Stock price with the rights attached to the stock, in a rights offering.
Riskless rate: Expected rate of return on an asset with guaranteed returns.
Road shows: Stage in the public offering process that the investment banker and issuing
firm will present information to prospective investors in a series of presentations.
Safety inventory: Extra inventory cover the demand while an order is being replenished
Scenario analysis: Analysis where earnings, cash flows or other variables can be
forecast under a variety of different scenarios, some positive and some negative.
Sector risk: Risk that the cash flows on projects will vary from expectations because of
events that affect an entire sector.
Secured debt: Bonds or debt with priority in claims on the assets of the firm, in the event
of bankruptcy.
Seed-money venture capital: Venture capital provided to start-up firms that want to test
a concept or develop a new product.
Serial bonds: Bonds where a percentage of the outstanding bonds mature each year, and
the maturity is specified on the serial bond.
Sinking funds: A fund into which a fixed amount is set aside each year to repay
outstanding bonds when they come due.
Skewness: Bias towards positive or negative returns in a distribution.
Special dividend: Dividends paid in addition to regular dividend infrequently.
Spin off: Action that separates out assets or a division and creates new shares with claims
on this portion of the business. Existing stockholders in the firm receive these shares in
proportion to their original holdings. Firm usually gives up control over the assets.
Split off: Action that separates out assets or a division and creates new shares with
claims on this portion of the business. Existing stockholders are given the option to
exchange their parent company stock for these new shares.
Split up: Action where firm splits into different business lines, distributes shares in these
business lines to the original stockholders in proportion to their original ownership in the
firm, and then ceases to exist.
Spot rate: Current market rate; Often used in the context of commodities or foreign
currency.
Standard deviation: Measure of the squared deviations of actual returns from the
expected returns. This is the square root of the variance.
Stand-by guarantees: Underwriting agreement where the investment banker provides
back-up support, in case the actual price falls below the offering price.

13
Standstill agreement: An agreement entered into between a hostile acquirer and a firm,
where the hostile acquirer (in return for a payment) agrees not to buy additional stock in
the firm for a period of time.
Start-up venture capital: Venture capital that allows firms that have established
products and concepts to develop and market them.
Statement of cash flows: A statement which specifies the sources of cash to the firm
from both operations and new financing, and the uses of this cash, during a period.
Step-down floating rate bond: A floating rate bond where the spread over the market
interest rate decreases over time instead of remaining fixed over the bondճ life.
Step-up floating rate bond: A floating rate bond where the spread over the market
interest rate increases over time instead of remaining fixed over the bondճ life.
Stock dividends: Dividend that takes the form of additional stock (in proportion to
existing holdings) in the firm.
Stock split: Action where additional shares are given to each stockholder in the firm, in
proportion to holdings in the firm.
Straight line depreciation: A depreciation method where an equal amount of the asset is
written off each year, over an estimated lifetime, to reflect its aging.
Strike Price (Exercise Price): Price at which the underlying asset in an option can be
bought (if it is a call) or sold (if it is a put).
Subordinated debentures: Unsecured bond with claims against assets that are
subordinated to the claims of other lenders.
Subscription price: Price at which a rights offering is made by a firm.
Super-majority amendment: an amendment requiring an acquirer to acquire more than
the 51% that would normally be required to gain control of a firm.
Synergy: Increase in value arising from the combination of two firms, projects or assets
that would not arise if the firms, projects or assets were independently run.
Synthetic rating: Bond rating estimated using a financial ratio or ratios for a firm. This
is in contrast to an actual rating that is usually provided by a ratings agency.
Tender offer: A solicitation where one firm offers to buy the outstanding stock of the
other firm at a specific price and communicates this offer in advertisements and mailings
to stockholders.
Terminal price (value): Expected value of an asset at the end of forecast period. For
instance, if you forecast cash flows for 10 years, the terminal value is the value at the end
of the 10th year.
Time line: A line depicting the magnitude and timing of cash flows on an investment.
Tobinճ Q: Ratio of firm value to replacement cost of the assets owned by the firm.
Tombstone advertisement: Advertisement containing details of an initial public
offering, the name of the lead investment banker, and the names of other investment
bankers involved in the issue.
Tracking stock: Stock issued on a division of a firm. The owner is entitled to the
earnings and cash flows of the division, and the stock trades on that basis. Generally, the
parent company continues to maintain full control over the division.

14
Trailing PE: Ratio of price per share to earnings per share over the most recent four
quarters.
Transactions exposure: Economic exposure faced by a firm because of exchange rate
movements which affect cash inflows and outflows on transactions entered into by the
firm.
Translation exposure: Effect of exchange rate changes on the current income statement
and the balance sheet of a firm with exposure to foreign currencies.
Treasury bills: Short-term obligations issued by the U.S. government.
Treasury stock approach: Approach for dealing with options in valuation, where the
exercise value of the options is added to the value of the equity in the firm, and the total
amount is divided by the number of shares outstanding, including those covered by the
options.
Trust preferred stock: Preferred stock, structured in such a way that the fixed dividend
that is tax deductible to the firm.
Underwriting guarantee: Guarantee of a fixed price (offering price) offered by an
investment banker in a public offering of securities.
Unlevered beta: The beta of a firm, under the scenario that it is all equity-financed. It is
determined by the businesses that the firm is in, and the operating leverage it maintains in
these businesses. Can be computed from the regression beta (top-down) or by taking a
weighted average of the betas of the different businesses (bottom-up).
Unsecured bonds: Bonds with the lowest claim on the cash flows and assets of the firm.
Up-and-out option: A put option that ceases to exist if the underlying asset falls below a
certain price.
Value ratio: Ratio of PBV Ratio to return on equity of a firm.
Value/sales ratio (VS),: Ratio of value per share to sales per share.
Variance: Measure of the squared deviations of actual returns from the expected returns.
Venture capital method: Value estimated by applying a price-earnings multiple to the
earnings of the private firm are forecast in a future year, when the company can be
expected to go public.
Venture capitalist: An entity that provides equity financing to small and often risky
businesses in return for a share of the ownership of the firm.
Warrants: Securities where holders receive the right to buy shares in the company at a
fixed price in the future; it is a long term call option on the equity of the firm.

15
 Variables Definition What it tries to Comments
measure
Abnormal Return See Excess Returns
Accounts Accounts Payable/ Use of supplier credit There is a hidden cost.
Payable /Sales Sales (See also days to reduce working By using supplier credit,
payable) capital needs (and to you may deny yourself
increase cash flows). the discounts that can be
gained from early
payments.
Accounts Accounts Receivable/ Ease with which you A focus on increasing
Receivable/Sales Sales grant credit to revenues can lead
customers buying companies to be too
your products and generous in giving credit.
services. While this may make the
revenue and earnings
numbers look good, it is
not good for cash flows.
In fact, one sign that a
company is playing this
short term gain is a surge
in accounts receivable.
Alpha Difference between the Measures whether When portfolio managers
actual returns earned on you are beating the talk about seeking alpha,
a traded investment market, after they are talking about
(stock, bond, real asset) adjusting for risk. In beating the market.
and the return you practice, though, it However, what may look
would have expected to can be affected by like beating the market
make on that what risk and return may just turn out to be a
investment, given its model you use to flaw in the risk and
risk. compute the expected return model that you
Alpha = Actual Return return. used. (With the CAPM,
- Expected return given for instance, small cap
risk and low PE stocks
In the specific case of a consistently have
regression of stock delivered positive alphas,
returns against market perhaps reflecting the
returns for computing fact that the model
the CAPM beta, it is understates the expected
measured as follows: returns for these groups)
(Jensen’s) Alpha = or sheer luck (In any
Intercept - Riskfree given year, roughly half
Rate (1 - Beta) of all active investors

16
 If the regression is run should beat the market).
using excess returns on
both the stock and the
market, the intercept
from the regression is
the Jensen's alpha.
Amortization See Depreciation &
Amortization
Annual Returns Returns from both price A percentage return The annual return is
appreciation and during the course of a always defined in terms
dividends or cash flow period that can be of what you iinvested at
generated by an then compared to the start of the period,
investment during a what you would have though there are those
year. For stocks, it is made on other who use the average
usually defined as: investments. price during the year.
(Price at end of year - The latter makes sense
Price at start + only if you make the
Dividends during investments evenly over
year) / Price at start of the course of the year. It
year cannot be less than
-100% for most assets
(you cannot lose more
than what you invested)
but can be more than
-100% if you have
unlimited liability. It is
unbounded on the plus
side, making the
distribution of returns
decidedly one-sided (or
asymmetric). Returns can
therefore never be
normally distributed,
though taking the natural
log of returns (the natural
log of zero is minus
infinity) may give you a
shot.
Asset Beta See unlevered beta
(corrected for cash)
Beta (Asset) See unlevered beta
(corrected for cash)
Beta (CAPM) It is usually measured Risk in an investment Regression betas have
using a regression of that cannot be two big problems:

17
 stock returns against diversified away in a (a) Measured right, they
returns on a market portfolio (Also called give you a fairly
index; the slope of the market risk or imprecise estimate of the
line is the beta. The systematic risk). true beta of a company;
number can change the standard error in the
depending on the time estimate is very large.
period examined, the (b) They are backward
market index used and looking. You get the beta
whether you break the for a company for the last
returns down into daily, 2 or last 5 years. If your
weekly or monthly company has changed its
intervals. business mix or debt ratio
over this time period, the
regression beta will not
be a good measure of the
predicted beta.
For a way around this
problem, you can try
estimating bottom-up
betas. (See bottom-up
beta)
Beta (Market) See Beta (CAPM)
Beta (Regression) See Beta (CAPM)
Beta (Total) See Total Beta
Book Debt Ratio See Debt Ratio (Book
Value)
Book Value of Book Value of Debt + A measure of the This is one of the few
Capital Book Value of Equity total capital that has places in finance where
(See book value of been invested in the we use book value, not so
invested capital) existing assets of the much because we trust
firm. It is what accountants but because
allows the firm to we want to measure what
generate the income the firm has invested in
that it does. its existing projects.
(Market value includes
growth potential and is
thus inappropriate)
There is a cost we incur.
Every accounting action
and decision (from
depreciation methods to
restructuring and one-
time charges) as well as
market actions (such as

18
 stock buybacks) can have
significant implications
for the book value. Large
restructuring charges and
stock buybacks can
reduce book capital
significantly.
Finally, acquisitions pose
a challenge because the
premium paid on the
acquisition (classified as
goodwill) may be for the
growth opportunities for
the target firm (on which
you have no chance of
earning money now).
That is why many
analysts net goodwill out
of book capital.
Book Value of Shareholder's equity on A measure of the The book value of equity,
Equity balance sheet; includes equity invested in the like the book value of
original paid-in capital existing assets of the capital, is heavily
and accumulated firm. It is what influenced by accounting
retained earnings since allows the firm to choices and stock
inception. Does not generate the equity buybacks or dividends.
include preferred stock. earnings that it does. When companies pay
large special dividends or
buy back stock, the book
equity will decrease. In
some cases, years of
repeated losses can make
the book value of equity
negative.
Book Value of Book Value of Debt + Invested capital Netting out cash allows
Invested Capital Book Value of Equity - mesures the capital us to be consistent when
Cash & Marketable invested in the we use the book value of
Securities operatinig assets of capital in the
(See book value of the firm. denominator to estimate
capital) the return on capital. The
numerator for this
calculation is after-tax
operating income and the
denominator should
therefore be only the
book value of operating

19
 assets (invested capital).
Bottom-Up Beta Weighted average Beta The beta for the There are two keys to
of the business or company, looking estimating bottom-up
businesses a firm is in, forward, based upon betas. The first is
adjusted for its debt to its business mix and defining the business or
equity ratio. The betas financial leverage. businesses a firm is in
for individual broadly enough to be
businessess are usually able to get at least 10 and
estimated by averaging preferably more firms
the betas of firms in that operate in that
each of these business. The second is
businesses and obtaining regression
correcting for the debt betas for each of these
to equity ratio of these firms.
firms. Bottom up betas are
generally better than
using one regression beta
because (a) they have
less standard error; the
average of 20 regressions
betas will be more
precise than any one
regression beta and (b)
they can reflect the
current or even expected
future business mix of a
firm.
Cap Ex/ Estimated by dividing
Depreciation the capital expenditures
by depreciation. For the
sector, we estimate the
ratio by dividing the
cumulated capital
expenditures for the
sector by the cumulated
depreciation and
amortization.
Capital (Book This is the book value
Value) of debt plus the book
value of common
equity, as reported on
the balance sheet.
Capital Capital Spending + Investment intended The accounting measure
Expenditures Investments in R&D, to create benefits of cap ex (usually found
exploration or human over many years; a in the statement of cash

20
 capital development + factory built by a flows under investing
Acquisitions manufacturing firm, activities) is far too
for instance. narrow to measure
investment in long term
assets. To get a more
sensible measure, we
therefore convert
expenses like R&D and
exploration costs (treated
as operating expenses by
most firms) into capital
expenditures. (See R&D
(capitalized) for more
details) and acquisitions,
including those funded
with stock. After all, if
we want to count the
growth from the latter,
we have to count the cost
of generating that
growth.
Cash Cash and Marketable Cash and close-to- At most firms, cash and
Securities reported in cash investments marketable securities are
the balance sheet. held by a firm for a invested in short term,
variety of motives: close to riskless
precautionary (as a investments. As a
cushion against bad consequence, they earn
events), speculative fairly low returns.
(to use on new However, since that is
investments) and what you would require
operational (to meet them to earn cash usually
the operating needs is a neutral investment; it
of the company). does not hurt or help
anyone. Investors,
though, may sometimes
discount cash in the
hands of some managers,
since they fear that it will
be wasted on a bad
investment.
Correlation with This is the correlation Measures how The beta for a stock can
the market of stock returns with closely a stock moves actually be written as:
the market index, using with the market. Beta = Correlation of
the same time period as stock with market *
the beta estimation (see Standard deviation of

21
 beta) . Bounded stock/ Standard deviation
between -1 and +1. of the market
As a consequence,
holding all else constant,
the beta for a stock will
rise as its correlation with
the market rises. If we do
not hold the standard
deviation of the stock
fixed, though, it is
entirely possible (and
fairly common) for a
stock to have a low
correlation and a high
beta (if a stock has a very
high standard deviation)
or a high correlation and
a low beta (if the stock
has a low standard
deviation.
Cost of Capital The weighted average Measures the current The cost of capital is a
of the cost of equity long-term cost of market-driven number.
and after-tax cost of funding the firm. That is why we use
debt, weighted by the market value weights
market values of equity (that is what you would
and debt: pay to buy equity and
Cost of Capital = Cost debt in the firm today
of Equity (E/(D+E)) + and the current costs of
After-tax Cost of Debt debt and equity are based
(D/(D+E)) upon the riskfree rate
today and the expected
risk premiums today.
When doing valuation or
corporate finance, you
should leave open the
possibility that the inputs
into cost of capital (costs
of debt and equity,
weights) can change over
time, leading your cost of
capital to change.
If you have hybrids (such
as convertible bonds),
you should try to break
them down into debt and
equity components and

22
 put them into their
respective piles. For what
to do with preferred
stock, see Preferred
stock.
Cost of Debt After-tax cost of debt = Interest is tax The marginal tax rate
(After-tax) Pre-tax Cost of debt (1 deductible and it will almost never be in
—marginal tax rate) saves you taxes on the financial statements
(See pre-tax cot of debt your last dollars of of a firm. Instead, look at
and marginal tax rate) income. Hence, we the tax code at what
compute the tax firms have to pay as a tax
benefit using the rate.
marginal tax rate. Note, though, that the tax
benefits of debt are
available only to money
making companies. If a
money losing company is
computing its after-tax
cost of debt, the marginal
tax rate for the next year
and the near-term can be
zero.
Cost of Debt (Pre- This is estimated by The rate at which the A company's pre-tax cost
tax) adding a default spread firm can borrow long of debt can and will
to the riskfree rate. term today. The key change over time as
Pre-tax cost of debt = words are long term - riskfree rates, default
Riskfreee rate + we implicitly assume spreads and even the tax
Default spread that the rolled over rate change over time.
The default spread can cost of short term We are trying to estimate
be estimated by (a) debt converges on the one consolidated cost of
finding a bond issued long term rate- and debt for all of the debt in
by the firm and looking today - we really the firm. If a firm has
up its current market don't care about what senior and subordinated
interest rate or yield to rate the firm debt outstanding, the
maturity (b) finding a borrowed at in the former will have a lower
bond rating for the firm past (a book interest interest rate and default
and using that rating to rate). risk than the former, but
estimate a default you would like to
spread or (c) estimating estimate one cost of debt
a bond rating for the for all of the debt
firm and using that outstanding.
rating to come up with
a default spread.
Cost of Equity In the CAPM: Cost of The rate of return Different investors
Equity = Riskfree Rate that stockholders in probably have different

23
 + Beta (Equity Risk your company expect expected returns, siince
Premium) to make when they they see different
In a multi-factor model: buy your stock. It is amounts of risk in the
Cost of Equity = implicit with equities same investment. It is to
Riskfree Rate + Beta and is captured in the get around this problem
for factor j * Risk stock price. that we assume that the
premium for factor j marginal investor in a
(across all j) company is well
diversified and that the
only risk that gets priced
into the cost of equity is
risk that cannot be
diversified away.
The cost of equity can be
viewed as an opportunity
cost. This is the return
you would expect to
make on other
investments with similar
risk as the one that you
are investing in.
Cost of preferred Preferred dividend The rate of return The cost of preferred
stock yield = Preferred that preferred stock should lie
(annual) dividends per stockholders demand somewhere between the
share/ Preferred stock for investing in a cost of equity (which is
price company riskier) and the pre-tax
cost of debt (which is
safer). Preferred
dividends are generally
not tax deductible; hence,
not tax adjustment is
needed.
In Latin America,
preferred stock usually
refers to common stock
with no voting rights but
preferences when it
comes to dividends.
Those shares should be
treated as common
equity.
D/(D+E) See Debt Ratio
D/E Ratio See Debt/Equity Ratio

24
Debt Interest bearing debt + Borrowed money For an item to be
Off-balance sheet debt used to fund categorized as debt, it
operations needs to meet three
criteria: (a) it should give
rise to a fixed
commitment to be met in
both good and bad times,
(b) this commitment is
usually tax deductible
and (c) failure to meet
the commitment should
lead to loss of control
over the firm. With these
criteria, we would
include all interest
bearing liabilities (short
term and long term) as
debt but not non-interest
bearing liabilities such as
accounts payable and
supplier credit. We
should consider the
present values of lease
commitments as debt.
Debt (Market Estimated market value Market's estimate of At most companies, debt
value) of book debt the value of debt is either never traded (it
used to fund the is bank debt) or a
business significant portion of the
debt is not traded.
Analysts consequently
assume that book debt =
market debt. You can
convert book debt into
market debt fairly easily
by treating it like a bond:
the interest payments are
like coupons, the book
value is the face value of
the bond and the
weighted maturity of the
debt is the maturity of the
bond. Discounting back
at the pre-tax cost of debt
will yield an approximate
market value for debt.

25
Debt Ratio (Book Book value of debt/ This is the It is a poor measure of
Value) (Book value of debt + accountant's estimate the true financial
Book value of equity) of the proportion of leverage in a firm, since
the book capital in a book value of equity can
firm that comes from not only differ
debt. significantly from the
market value of equity,
but can also be negative.
It is, however, often the
more common used
measure and target for
financial leverage at
firms that want to
maintain a particular debt
ratio.
Debt Ratio Market value of debt/ This is the proportion The market value debt
(Market Value) (Market value of debt + of the total market ratio, with debt defined
Market value of equity) capital of the firm to include both interest
that comes from debt. bearing debt and leases,
will never be less than
0% or higher than 100%.
Since a signfiicant
portion or all debt at
most firms is non-traded,
analysts often use book
value of debt as a proxy
for market value. While
this is a resonable
approximation for most
firms, it will break down
for firms whose default
risk has changed
significantly since the
debt issue. For these
firms, it makes sense to
convert the book debt
into market debt by
treating the aggregate
debt like a coupon bond,
with the interest
payments as coupons and
discounting back to today
using the pre-tax cost of
debt as the discount rate.
Debt/Equity Ratio Debt/ Equity This measures the The debt to equity ratio

26
 number of dollars of and the debt to captial
debt used for every ratio are linked. In fact,
dollar of equity. Debt/Equity = (D/
(D+E))/ (1- D/(D+E))
Thus, if the debt to
capital is 40%, the debt
to equity is 66.667%
(.4/.6)
In practical terms, the
debt to capital ratio is
used in computing the
cost of capital and the
debt to equity to lever
betas.
Default spread Default spread: Measures the The default spread
Difference between the additional premium should always be greater
pre-tax cost of debt for demanded by lenders than zero. If the riskfree
a firm and the riskfree to compensate for rate is correctly defined,
rate risk that a firm will no firm, no matter how
default. safe, should be able to
borrow at below this rate.
The default spread can be
computed in one of three
ways:
a. Finding a traded bond
issued by a company and
looking up the yield to
maturity or interest rate
on that bond.
b. Finding a bond rating
for a firm and using it to
estimate the default
spread
c. Estimating a bond
rating for a firm and
using it to estimate the
default spread
Deferred Tax Deferred Tax asset (on Measures the credit For this asset to have
(Asset) balance sheet) that the firm expects value, the firm has to
to get in future anticipate being a going
periods for concern, profitable and
overpaying taxes in being able to claim the
current and past overpayments as tax
periods. The credit deduction in future time
will take the form of periods. In other words,

27
 lower taxes in future there would be no value
periods (and a lower to this asset if the firm
effective tax rate) were liquidated today.
Deferred Tax Deferred tax laibility Measures the liability It is not clear that this is a
(Liability) (on balance sheet) that the firm sees in liability in the
the future as a conventional sense. If
consequences of you liquidated the firm
underpaying taxes in today, you would not
the current or past have to meet this liablity.
perios. The liability Consequently, it should
will take the form of not be treated like debt
higher taxes in future when computing cost of
periods (and a higher capital or even when
effective tax rate) going from firm value to
equity value. The most
effective way of showing
it in a valuaton is to build
it into expected tax
payments in the future
(which will result in
lower cash flows)
Depreciation and Accounting write-off of Reflects the depletion Accounting depreciation
Amortization capital investments in valuation of and amortization usually
from previous years. existing assets - is not a good reflection of
depreciation for economic depletion,
tangible and since the depreciation
amortization for choices are driven by tax
intangible. rules and considerations.
Consequently, you may
be writing off too much
of some assets and too
little of others. While
depreciation is an
accounting expense, it is
not a cash expense.
However, it can affect
taxes because it is tax
deductible. The tax
benefit from depreciation
in any given year can be
written as:
Tax benefit from
depreciation =
Depreciation * Marginal
tax rate

28
 Amortization shares the
same effect, if it is tax
deductible but it often is
not. For instance,
amortization of goodwill
generally does not create
a tax benefit.
One final point. Most US
firms maintain different
sets of books for tax and
reporting purposes. What
you see as depreciation in
an annual report will
deviate from the tax
depreciation.
Dividend Payout Dividends/ Net Income Measures the The dividend payout
Usually cannot be proportion of ratio is widely followed
compute for money earnings paid out and proxy for a firm's growth
losing companies and inversely, the amount prospects and place in the
can be greater than retained in the firm. life cycle. High growth
100%. firms, early in their life
cycles, generally have
very low or zero payout
ratios. As they mature,
they tend to return more
of the cash back to
investors causing payout
ratios to increase. In
many markets, as
companies have chosen
to switch to stock
buybacks as an
alternative to dividends,
this ratio has become less
meaningful. One way to
adapt it to switch to an
augmented payout ratio:
Augmented Payout Ratio
= (Dividends +
Buybacks)/ Net Income
Dividend Yield Dividends per share/ Measures the portion The dividend yield is the
Stock Price of your expected cash yield that you get
return on a stock that from investiing in stocks.
will come from Generally, it will be
dividends; the lower than what you can

29
 balance has to be make investing in bonds
expected price issued by the same
appreciation. company because you
will augment it with price
appreciation. There are
some stocks that have
dividend yields that are
higher than the riskfree
rate. While they may
seem like a bargain, the
dividends are not
guaranteed and may not
be sustainable. Studies of
stock returns over time
seem to indicate that
investing in stocks with
high dividend yields is a
strategy that generates
positive excess or
abnormal returns.
Finally, the oldest cost of
equity model is based
upon adding dividend
yield to expected growth:
Cost of equity =
Dividend yield +
Expected growth rate
This is true only if you
assume that the firm is in
stable growth, growing at
a cosntant rate forever.
Dividends Dividends paid by firm Cash returned to Dividends are
to stockholders stockholders discretionary and firms
do not always pay out
what they can afford to in
dividends. This is
attested to by the large
and growing cash
balances at firms. Models
that focus on dividends
often miss two key
components: (a) Many
companies have shifted
to return cash to
stockholders with stock
buybacks, instead of

30
 dividends and (b) The
potential dividends can
be very different from
actual dividends. For a
measure of potential
dividends, see Free
Cashflow to Equity.
Earnings Yield Earnings per share/ This is the inverse of Analysts read a lot more
Stock price the PE ratio and into earnings yields than
mesures roughly they should. There are
what the firm some who use it as a
generates as earnings measure of the cost of
for every dollar equity; this is true only
invsted in equity. It is for mature companies
usually compared to with no growth
the riskfree or opportunities with
corporate bond rate potential excess returns.
to get a measure of One nice feature of
how attractive or earnings yields is that
unattractive equity they can be computed
investments are. and used even if earnings
are negative. In contrast,
PE ratios become
meaningless when
earnings are negative.
EBITDA Earnings before interest Measures pre-tax EBITDA is used as a
expenses(or income), cash flow from crude measure of the
taxes, depreciation and operations before the cash flows from the
amortization firm makes any operating assets of the
investment back to firm. In fact, there are
either maintain some who argue that it is
existing assets or for the cash available to
growth service interest and other
debt payments. That view
is misguided. Firms that
have large depreciaton
charges often have large
capital expenditure needs
and they still have to pay
taxes. In fact, it is
entirely possible for a
firm to have billions in
EBITDA and no cash
available to service debt
payments (See Free Cash

31
 Flow to the Firm for a
more complete measure
of operating cash flow)
Economic Profit, (Return on Invested Measures the dollar To the degree that the
Economic Value Capital - Cost of excess return book value of invested
Added or EVA Capital) (Book Value generated on capital capital measures actual
of Invested Capital) invested in a capital invested in the
(See Excess Returns) company operating assets of the
firm and the after-tax
operating is a clean
mesure of the true
operating income, this
captures the quality of a
firm's existing
investments. As with
other single measures,
though, it can be easily
gamed by finding ways
to write down capital
(one-time charges), not
show capital invested (by
leasing rather than
buying) or overstating
current operating income.
Effective tax rate Taxes payable/ Taxable Measures the average Attesting to the
income tax rate paid across effectiveness of tax
all of the income lawyers, most companies
generated by a firm. report effective tax rates
It thus reflects both that are lower than their
bracket creep (where marginal tax rates. The
income at lower difference is usually the
brackets get taxed at source of the deferred tax
a lower rate) and tax liability that you see
deferral strategies reported in financial
that move income statements. While the
into future periods. effective tax rate is not
particularly useful for
computing the after-tax
cost of debt or levered
betas, it can still be
useful when computing
after-tax operating
income (used in the Free
Cashflow to the Firm and
return on invested capital

32
 computations) at least in
the near term. It does
increasingly dangerous to
assume that you can
continue to pay less than
your marginal tax rate for
longer and longer
periods, since this
essentially allows for
long-term or even
permanent tax deferral.
Enterprise Value Market value of equity Measures the In practice, analysts often
+ Market value of debt market's estimate of use book value of debt
- Cash + Minority the value of operating because market value of
Interests assets. We net out debt may be unavailable
cash because it is a and the minority interest
non-operating assets item on the balance
and add back sheet. The former
minority interests practice can be
since the debt and troublesome for
cash values come distressed companies
from fully where the market value
consolidated of debt should be lower
financial statements. than book value and the
(See Minority latter practice is flawed
Interests for more because it measures the
details) book value of the
minority interests when
what you really want is a
market value for these
interests.
This computation can
also sometimes yield
negative values for
companies with very
large cash balances.
While this represents a
bit of puzzle (how can a
firm trade for less than
the cash on its balance
sheet?), it can be
explained by the fact that
it may be impossible to
take over the firm and
liquidiate it or by the
reality that the cash

33
 balance you see on the
last financial statment
might not be the cash
balance today.
Enterprise Value/ (Market value of equity Market's assessment By netting cash out of the
Invested Capital + Debt - Cash + of the value of both the numerator and
Minority Interests)/ operating assets as a the denominator, we are
(Book value of equity + percentage of the trying to focus attention
Debt - Cash + Minority accountant's estimate on just the operating
Interests) of the capital assets of the firm. This
(See descriptions of invested in these ratio, which has an equity
Enterprise value and assets analog in the price to
Invested Capital ) book ratio, is determined
most critically by the
return on invested capital
earned by the firm; high
return on invested capital
will lead to high
EV/Capital ratios.
Enterprise Value/ (Market value of equity Multiple of pre-tax, Commonly used in
EBITDA + Debt - Cash + pre-reinvestment sectors with big
Minority Interests)/ operating cash flow infrastructure
EBITDA that the firm trades at investments where
(See descriptions of operating income can be
Enterprise Value and depressed by
EBITDA) depreciation charges.
Allows for comparison of
firms that are reporting
operating losses and
diverge widely on
depreciation methods
used. It is also a multiple
used by acquirers who
want to use significant
debt to fund the
acquisition; the
assumption is that the
EBITDA can be used to
service debt payments.
Cash is netted out from
the firm value because
the income from cash is
not part of EBITDA.
However, the same can
be said of minority

34
 holdings in other
companies - the income
from these holdings is
not part of EBITDA -
and the estimated value
of these holdings should
be netted out as well.
With majority holdings,
the consolidation that
follows creates a
different problem: the
market value of equity
includes only the portion
of the subsidiary owned
by the parent but all of
the other numbers in the
computation reflect all of
the subsidiary. This
should explaiin why
minority interests are
added back to the
numerator.
Enterprise Value/ (Market value of equity Market's assessment While the price to sales
Sales + Debt - Cash + of the value of ratio is a more widely
Minority Interests)/ operating assets as a used multiple, the
Revenues percentage of the enterprise value to sales
revenues of the firm. ratio is more consistent
because it uses the
market value of operating
assets (which generate
the revenues) in the
numerator.
Equity EVA (Return on Equity - Measures the dollar To the degree that the
Cost of Equity) (Book excess return inputs into the equation
Value of Equity) generated on equity are reasonable estimates,
(See Excess Returns invested in a this becomes a measure
(on Equity)) company of the success a company
has shown with its
existing equity
investments. However,
both the return on equity
and book value of equity
are accounting numbers,
and can be skewed by
decisions (such as stock

35
 buybacks and
restructuring charges). At
the limit, it becomes
meaningless when the
book value of equity
becomes negative.
Equity ((Capital Expenditures Measures the The conventional
Reinvestment - Depreciation) - proportion of net measure of equity
Rate Change in non-cash income that is reinvestmnt is the
Working Capital - reinvested back into retention ratio, which
(Principal repaid - New the operating assets looks at the proportion of
Debt Issued))/ Net of the firm earnings that do not get
Income paid out as dividends.
The equity reinvestment
is both more focused and
more general. It is more
focused because it looks
at the portion of the
earnings held back that
get invested into the
operating assets of the
firm and more general
because it can be a
negative value (for firms
that are letting their
assets run down) or
greater than 100% (for
firms that are issuing
fresh equity and
investing it back into the
business).
Equity Risk Expected Returns on Premium over the The ERP is a key
Premium (ERP) Equity Market Index - riskfree rate component of the cost of
Riskfreee Rate demanded by equity for all companies,
investors for since it is multiplied by
investing the average the beta to get to the cost
risk stock of equiity. If you over
estimate the ERP, you
are going to under value
all companies.
Equity Risk Average Annual Return Actual premium The historical risk
Premium - on Stocks - Average earned by investors premium is usually
Historical Annual Return on on stocks, relative to estimated by looking at
Riskfree investment riskfree investment, long time period. For
over the time period instance, in the United

36
 States, it is usually
estimated over eight
decades (going back to
1926). There are two
dangers in using this
historical risk premium.
The first is that the long
time period
notwithstanding, the
historical risk premium is
an estimate with a
significant standard error
(about 2% for 80 years of
day). The second is that
the market itself has
probably changed over
the last 80 years, making
the historical risk
premium not a good
indicator for the future.
Equity Risk Growth rate implied in Reflects the risk that The implied equity risk
Premium - today's stock prices, investors see in premium moves
Implied given expected cash equities rght now. If inversely with stock
flows and a riskfree investors think prices. When stock prices
rate. (Think of it as a equities are riskier, go up, the implied equity
internal rate of return they will pay less for risk premium will be
for equities stocks today. low. When stock prices
collectively). go down, the implied
premium will be high.
Notwithstanding the fact
that you have to use an
expected growth rate for
earnings and a valuation
model, the implied equity
risk premium is both a
forward looking number
(relative to historical
premiums) and
constantly updated.
Excess Returns Return on Invested Measure the returns Excess returns are the
Capital - Cost of capital earned over and source of value added at
above what a firm a firm; positive net
needed to make on an present value investments
investment, given its and value creating
risk and funding growth come from excess

37
 choices (debt or returns. However, excess
equity). returns themselves are
reflections of the barriers
to entry or competitive
advantages of a firm. In a
world with perfect
competition, no firm
should be able to
generate excess returns
for more than an instant.
Excess Returns Return on Equity - Cost Measures the return To generate excess
(on equity) of Equity earned over and returns. you have to bring
above the required something special to the
return on an equity table. For firms, this may
investment, given its come from a brand name,
risk. It can be at the economies of scale or a
level of the firm patent. For investors, it is
making real more difficult but it can
investments and at be traced to better
the level of the information, better
investor picking analysis or more
individual stocks for discipline than other
her portfolio. investors.
Firm Value Market Value of Equity Measures the market Since the value of the
+ Market Value of Debt value of all assets of firm includes both
a firm, operating as operating and non-
well as non- operating assts, it will be
operating. greater than enterprise
value. To the extent that
we are looking at how
value relates to operating
items (operating income
or EBITDA), you should
not use firm value but
should use enterprise
value instead; the income
from cash is not part of
operating income or
EBITDA.
Fixed Fixed Assets/ Total Measures how much This ratio should be
Assets/Total Assets of a firm's higher for manufacturing
Assets investments are in firms than for service
tangible assets. firms and reflects the bias
in accounting towards
tangible assets. Many

38
 lenders seem to share this
bias and are willing to
lend more to firms with
significant fixed
assets.The ratio can also
be affected by the age of
the assets, since older
assets, even if
productive, will be
written down to lower
values.
Free Cash Flow to FCFE = Net Income - Measures cash flow This is a post-debt cash
Equity (FCFE) (Capital Expenditures - left over for equity flow. When it is positive,
Depreciation) - Change investors after taxes, it measures what can be
in non-cash Working reinvestment needs paid out by the firm
Capital - (Principal and debt needs are without doing any
repaid - New Debt met. For a growing damage to its operations
Issued) firm, debt cash flows or growth opportunities.
can be a source of In other words, it is the
positive cash flows; potential dividend and
new debt brings cash can be either paid out as
to equity investors. such or used to buy back
stock. When it is
negative, it indicates that
the firm will have raise
fresh equity. When we
discount FCFE in a
valuation model, we are
implicitly assuming that
no cash builds up in the
firm and the present
value will already
incorporate the effect of
future stock issues.
(Discounting negative
FCFE in the early years
will push down the value
per share today; think of
that as the dilution effect)
Free Cash Flow to FCFF = EBIT(1-t) - Measures cash flow This is a pre-debt cash
Firm (FCFF) (Capital Expenditures - left over for all flow. That is why we
Depreciation) - Change claimholders in the start with operating
in non-cash Working firm (lenders and income, rather than net
Capital equity investors) income (which is after
after taxes and interest expenses) and act

39
 reinvestment needs like we pay takes on
have been met. operating income. In
effect, we are acting like
we have no interest
expenses or tax benefits
from these interest
expenses when
computing cash flows.
That is because these
cash flows are discounted
back at a cost of capitatl
that already reflects the
tax benefits of borrowing
(through the after-tax
cost of debt).
A positive free cash flow
to the firm is cash
available to be used to
make payments to debt
(interest expenses and
prinicipal payments) and
to equity (dividends and
stock buybacks).
A negative free cash flow
to the firm implies that
the firm faces a cash
deficit that has to be
covered by either issuing
new stock or new debt
(the debt ratio used in the
cost of capital determines
the mix).
Fundamental Retention Ratio * Expected growth in Since the retention ratio
growth in EPS Return on Equity earnings per share if cannot exceed 100%, this
(See definitions of both the firm maintains caps the growth in
items) this return on equity earnings per share at the
on new investment return on equity, if the
and invests what it return on equity is stable.
does not pay out as However, this formula
dividends in these will yield an incomplete
new investments. measure of growth when
the return on equity is
changing on existing
assets. In that case, there
will be an additional
component to growth that

40
 we can label efficiency
growth. Thus, doubling
the return on equity on
existing assets from 5%
to 10% will generate a
growth rate of 100%
even if the retentiion
ratio is zero.
Fundamental Equity Reinvestment Measures the growth Since the equity
growth in net Rate * Non-cash Return rate in net income reinvestment rate can be
income on Equity from operating greater than 100% or less
(See definitions of both assets, if the equity than 0%, this measures
items) reinvestment rate and implies that the growth in
return on equity net income can exceed
remain unchanged. growth in earnings per
share (for firms that issue
new stock to reinvest) or
be negative (for firms
with negative equity
reinvestment rates). As
with the other
fundamental growth
measures, this one
measures growth only
from new investments;
there can be an additional
component that can be
traced to improving or
dropping return on equity
on existing investments.
Fundamental Reinvestment Rate * Measures the growth The growth in operating
growth in Return on Capital rate in after-tax income is a function of
operating income operating income, if both how much a firm
the reinvestment rate reinvests back
and return on capital (reinvestment rate) and
remain unchanged. how well it reinvests its
money (the return on
capital). As a general
rule, growth created by
reinvesting more at a
return on capital that is
more (less) than the cost
of capital will create
(destroy) value. A firm's
growth rate in the short

41
 term can be higher or
lower than this number,
to the extent that the
return on capital on
existing assets increases
or decreases.
Goodwill Price paid for equity in Measures the In reality, goodwill is not
an acquisition - Book intangible assets of an asset but a plug
value of equity in the target company variable used to balance
acquired company the balance sheet after an
acquisiton. It is
composed of three parts -
the value of the growth
assets of the target firm
(which would not have
been reflected in the
book value), the value of
synergy and control and
any overpayment made
by the firm. How we deal
with goodwill will vary
depending on its source.
If it is for growth assets,
it creates inconsistencies
in balance sheets since
we do not allow firms to
record growth assets that
may be generated
internally. If it is for
synergy and control, it
should be reflected as
additional value in the
consolidated balance
sheet, but that value has
to be reassessed, given
the actual numbers. If it
is an overpayment, it is
money wasted. When we
do return on invested
capital, for instance, we
clearly want to subtract
out the first from
invested capital but we
should leave the last two
elements in the number.

42
Gross Margin Gross Profit/ Sales
(See Gross Profit)
Gross Profit Revenues - Cost of Measures the profits The line between gross
Goods Sold generated by a firm and operating profit is an
after direct operating artifical one. For the
expenses but before most part, the expenses
indirect operating that are subtracted out to
expenses, taxes and get to gross profit tend to
financial expenses. be costs directly
traceable to the product
or service sol and the
expenses that are treated
as indirect are expenses
such as selling, general
and administrative costs.
If we treat the latter as
fixed costs and the
former as variable, there
may be some information
in the gross profit.
Historical Equity See Equity Risk
Risk Premium Premium (Historical)
Historical Growth Growth rate in earnings Measures how Historical growth rates
Rate in the past. quickly a firm's can be sensitive to
(Earnings earnings have grown starting and endiing
(today)/Earning (n in the past. periods and to how the
years ago))^(1/n)-1 average is estimated -
arithmetic averages will
generally yield higher
growth rates than
geomteric averages.
While knowing past
growth makes us feel
more comfortable about
forecasting future
growth, history suggests
that past growth is not a
good predictor of future
growth.
Hybrid secuity A security that Capital invested (not Hybrid securities are best
combines the features current market value) dealt with, broken up into
of debt and equity of issued security. debt and equity
components. For
convertible bonds, for
instance, the conversion

43
 option is equity and the
rest is debt. Preferred
stock is tougher to
categorize and may
require a third element in
the cost of capital.
Implied Equity See Equity Risk
Risk Premium Premium (Implied)
Insider Holdings Shares held by insiders/ Measures how much If we assume that
% Shares outstanding of the stock is held insiders are or are allied
by insiders in a with the incumbent
company. The SEC managers of the firm, this
definition of insdiers ratio becomes an inverse
includes those who measure of how much
hold more than 5% of influence outside
the shares. stockholders have over
this firm. The higher this
ratio, the less of a role
outside investors willl
have in the management
of a company...
This can also have an
effect in how we think
about and measure risk.
If the insdier holdings are
high, the assumption we
make about marginal
investors being well
diversifed in risk and
return models may come
under assault.
Institutional Shares held by Measures how much If institutional investors
Holding % institutions/ Shares of the stock is held hold a substantial
outsanding by mutual funds, proportion of a firm, the
pension funds and assumption we make
other institutional about investors being
investors. well diversifed is well
founded. Conseqently,
we can safely assume
that only non-
diversifiable risk has to
be priced into the cost of
equity and ignore risk
that can be diversified
away.

44
Interest coverage Interest coverage ratio Measures the margin There are a number of
ratio = EBIT / Interest for error the firm has ratios that measure a
Expense in making its interest firm's capacity to meet its
expenses. If this ratio debt obligatiion. The
is high, the firm has fixed charges ratio, for
much more margin instance, is the ratio of
for error and is EBITDA to total fixed
therefore safer (from charges. In estimating
the lender's this ratio, you should try
perspective) to get a measure of the
operating income that the
firm can generate in a
normal year (this may
require looking at
operating income over an
economic cycle or over a
period of time) relative to
its interest expenses.
Other things remaining
equal, the higher this
ratio, the higher the
rating and the lower the
default spread for a firm.
Inventory/ Sales Estimated by dividing Measures how much When this ratio is high, a
the cumulated inventory the firm firm will find that its
inventory for the sector needs to hold to cash flows lag its
by the cumulated sales sustain its revenues. earnings. The magnitude
for the sector of this number will vary
across businesses.
Generally, businesses
that sell high priced
products where sales
turnover ratios are low
(luxury retailers, for
instance) will have to
maintain high inventory.
Invested Capital See Book Value of
Invested Capital
Leases Expense for current Measured the While accountants and
(Operating) year is shown as part of reduction in income tax authorities draw a
operating expenses; created by having to distinction between
commitments for future meet lease operating and capital
years are shown in obligations in current leases, they look much
footnotes. period. the same from a financial
perspective. They are

45
 both the equivalent of
borrowing, though lease
commitment can be
viewed as more focused
borrowing (because it is
tied to an individual asset
or site) and more flexible
(a firm can abandon an
individual lease without
declaring bankruptcy)
than conventional debt.
The best approach is to
use the pre-tax cost of
debt as the discount rate
and discount future lease
commitments back to
today to get a debt value
for operating leases. This
will also create a leased
asset, which has to be
depreciated. As a result,
operating income will
have to be restated:
Adjusted Operating
Income = Operating
Income + Current year's
lease expense -
Depreciation on leased
asset
Leases (Capital) Commitments Measures the debt Accountants do for
converted into debt (by equivalent of lease capital leases what we
discounting at a pre-tax commitments. suggested that they need
cost of debt) and shown to do for operating
on balance sheet. leases. One cost of
Imputed interest having them do it (rather
expenses and than yourself) is that you
depreciation shown on do not control when the
income statement. present value is
computed (usually at the
time of the financial
statement) and the pre-
tax cost of debt used.
Marginal tax rate Tax rate on last dollar Measures the taxes The marginal tax rate is
or next dollar of you will have to pay best located in the tax
income. on additional income code for the country in

46
 that you will generate which a company
on new investments operates. In the United
and the savings that States, for instance, the
you will obtain from marginal federal tax rate
a tax deduction. is 35%. With state and
local taxes added on, this
number will increase (to
38-40%). For companies
operating in multiple
countries, we can use one
of two approximations.
One (the easier one) is to
assume that income will
eventually have to make
its way to the company's
domicile and use the
marginal tax rate for the
country in which the
company is incorporated.
The other is to use a
weighted average tax
rate, with the weights
based on operating
income in each country,
of the marginal tax rates.
Market Estimated market value Market's estimate of When a firm has non-
Capitalization of shares outstanding, what the common traded or multiple clssses
obtained by multiplying stock in a firm is of shares, the market
the number of shares worth. capitalization should
outstanding by the include the value of all
share price. shares and not just the
most liquid class of
shares. This may require
assuming a market price
for non-traded shares.
Market Debt Ratio See Debt Ratio (Market
value)
Market value of Market value of Market's estimate of Most analyses assume
equity common shares what the equity in a that market capitalization
outstanding + Market firm is worth. = market value of equity.
value of other equity However, when a firm
claims on the firm has used warrants,
convertible bonds or
even management
options, it has issued

47
 equity claims in the form
of options. In theory, at
least, these options
should be valued and
treated as part of the
market value of equity.
Minority Interests Minority interests Accountant's Minoerity interests are a
(liability on balance estimate of the value logical outgrowth of full
sheet) of the portion of a consolidation. When you
fully consolidated own 60% of a subsidiary,
subsidiary that does you are forced to fully
not belong to the consolidate and show
parent company. 100% of the subsidiary's
earnings and assets as
belonging to the parent
company. Since the
parent company owns
only 60%, the accounting
conventiona requires you
to show the 40% of the
subsidiary that does not
belong to you as a
minority interests. The
problem, though, is that
most computations
requiring minority
interests (enterprise
value, for instance)
require an estimated
market value for this
minority interest. To
convert the book value of
minority interests into a
market value, you could
try to estimate a price to
book ratio and apply this
to the minority interests.
Net Capital Capital Expenditures - Measures the net Your assumptions about
Expenditures Depreciation investment into the net capital expenditures
(See description of each long term assets of a will largely determine
item) business. what happens to your
capital base over time. If
you assume that net
capital expenditures are
zero and you ignore

48
 working capital needs,
your book capital will
stay frozen over time. If
you concurrently assume
that the operating income
will go up 2 or 3% every
year, you will very
quickly find your return
on capital rising to
untenable levels. That is
why, in stable growth, we
assume that the capital
base increases in lock-
step with the operating
income (thus keeping
return on capital fixed).
In any given year, for a
firm, the net capital
expendiure number can
be negative. This can
often be a reflection of
the lumpiness of capital
expenditures, where
firms invest a lot in one
year and not very much
in subsequent years In
special cases, it may
represent a deliberate
strategy on the part of the
firm to shrink itself over
time, in which case teh
growth rate should be
negative.
Net Margin Net Income/ Sales Measures the profit Net margins vary widely
mark-up on all costs across sectors and, even
(operating and within a sector, widely
financila) on the across firms as a
products and services reflection of the pricing
sold by the firm. strategy adopted by the
firm. Some firms adopt
low-margin, high volume
strategies whereas others
go for high-margin, low
volume strategies. Much
as we would like to get
the best of both worlds -

49
 high margins and high
volume - it is usually
infeasible.
Net margins will also be
affected by how much
debt you choose to use to
fund your operations.
Higher debt will lead to
higher interest expenses
and lower net income and
net margins.
Non-cash ROE (Net Income - Interest Measures the return For firms with substantial
income from cash) / earned on the equity cash balances, the non-
(Book value of equity - invested in the cash ROE provided a
Cash and Marketable operating assets of cleaner measure of the
securities) the firm. It eliminates performance of the firm.
cash from the mix in After all, cash is usually
both the numerator invested in low-return,
and the denominator. close to riskless assets
and including it (as we
do in return on equity)
can depress the return on
equity.
Non-Cash Non-cash Working Total Investment in When service oriented
Working Capital Capital = Inventory + short term assets of a and retail firms want to
Other Current Assets + business. grow, their invstment is
Accounts Receivable often in short term assets
-Accounts Payable - and the non-cash
Other Current working capital measures
Liabilities this reinvestment. We
[Current assets exclude cash from
excluding cash - current assets because it
Current liabilities is not a wasting assets if
excluding interest it is invested to earn a
bearing debt) fair market return (which
may be the riskless rate if
the investment in is
treasury bills) and short
term interest bearing debt
from current liabilities,
because we include it
with other interest
bearing debt in
computing the cost of
capital.

50
Non-cash Change in non-cash New investment in An increase in non-cash
Working Capital working capital from short term assets of a working capital is a
(Change) period to period business. negative cash flow since
it represents new
investment. A decrease in
non-cash working capital
is a positive cash flow
and represents a drawing
down on existing
investment.
This is a volatile number
and it is not uncommon
to see a year with a large
increase followed by a
year with a large
decrease. It makes sense
to look at either averages
over time or at the total
non-cash working capital
as a percentage of
revenues or operating
income.
Operating Income Operating income or Income generated A good measure of
Earnings before interest before financial and operating income will
and taxes capital expenditures. subtract only operating
expenses from revenues.
In practice,, though,
acountants routines treat
capital expenditures in
some businesses as
operating expenses
(R&D at technology
firms, exploration costs
at natural resource
companies, training
expenses at consulting
firms) and financial
expenses also as
operating expenses
(operating leases for all
firms). To measure
operating expenses
correctly, we have to
correct for these errors.
Operating Income Earnings before interest After-tax earnings To prevent double

51
(After-tax) and taxes (1 - tax rate) generated by a firmcounting the tax benefit
from its operating from interest expenses,
assets befroe you should estimate
financial and capital
hypothetical taxes on the
expenses. operating income and not
use actual or cash taxes
paid. (See definiton of
effective tax rate for
discussion of whether to
use the marginal or
effective tax rate).
Operating Margin After-tax Operating Measures the post- Unlike net profit margins
(After-tax) Margin = EBIT(1-t) / tax mark-up on which are affected by
Sales operating costs for debt ratios and financial
products and services leverage, operating profit
sold by the firm. margins can be compared
across firms with very
different debt ratios. The
return on invested capital
for a firm can be stated in
terms of the after-tax
operating margin and the
sales turnover ratio
(Sales/ Book Value of
Invested Capital)
Return on capital =
Operating
Operating Margin Operating Margin = Measures the pre-tax Operating margins can be
(Pre-tax) Operating Income/ mark-up on operating compared across
Sales costs for products companies with different
and services sold by debt ratios and tax rates,
the firm. since it is prior to
financial expenses and
taxes.
Preferred Stock Book value of Preferred Capital raised from Preferred stock shares
Stock preferred stock features with debt (fixed
dividends that are often
cumulative) and equity
(failure cannot push you
into bankruptcy. This is
one of the few casts
where you will allow for
a third component in the
cost of capital, with its
own cost.

52
Price Earnings Price per share/ Market value of The conventional
Ratio (PE) Earnings per share (or) equity as a multiple computation of PE ratios
Market Capitalization/ of equity earnings is based upon per share
Net Income values, but this can be
problematic when there
(See Earnings Yield) are options outstanding;
some analysts use diluted
earnings per share while
others use primary
earnings per share. In
reality, neither approach
does a good job of
dealing with options,
since an option is either
counted as a share or not.
A far more consistent
definition of PE ratio
would be based on
aggregate numbers and
reflect the value of the
options outstanding:
PE corrected for options
= (Market Capitalization
+ Value of Options)/ Net
Income
The PE ratio for a firm
will be determined by its
risk (cost of equity),
growth (in equity
earnings) and efficiency
of growth (payout ratio).
If the earnings are
negative, the PE ratio is
not meaningful.
Price to Book Price per share/ Book Market value of The price to book ratio is
Ratio (PBV) value of equity per equity as a multiple used as a simple measure
share (or) of the accountant's of undervaluation; in
Market Capitalization/ estimate of equity fact, investors who buy
Book value of equity value low price to book ratios
are categorized as value
investors. The most
critical determinant of
the price to book ratio for
a firm is the return on
equity, with high return
on equity stocks trading

53
 at high price to book
ratios.
Price to Sales Market Capitalization/ Market value of While this multiple is
Ratio Revenues equity as a multiple used frequently with
of revenues technology firms
generated by a firm (especially if they are not
making money) and with
retail firms, it is
internally inconsistent.
The numerator measures
equity value but the
denominator, revenues,
does not accrue to equity
investors alone. A more
consistent version of this
multiple is the enterprise
value to sales ratio.
The price to sales ratio is
determined most
critically by the net profit
margin; high margin
companies will tend to
have high price to sales
ratios.
Provision for ____ Accounting charge to Smoothed out A provision is not a cash
(Bad debts, income to cover measure of lumpy expense. In the period
Litigations costs potential or likely expenses that that the provisional
etc.) expenses in future otherwise would charge is made, no cash
periods. make earnings much expense is incurred, and
more volatile. the reported earnings will
be lower than cash
earnings. In subsequent
periods, when the
expected expense
materializes, it is offset
against the provision and
the effect on earnings in
those periods will be
muted. If all firms were
consistent about how
they set provisions and
set them equal to
expected, provisional
charges are useful
because they smooth

54
 earnings for a good
reason. However, if some
companies are aggressive
about their loss estimates
(set provisions too low)
and others are too
conservative (set
provisions too high), we
will overstate the
earnings of ther former
and understate earnings
for the latter.
R&D See Research and
Development Expenses
R-squared Beta^2* Variance of Proportion of a While the R-squared and
(Market the market/ Variance of stock's (asset's) risk the correlation of a stock
regression) the stock (asset) that can be explained with the market seem to
(Usually output from by the market. measure the same thing
regression of stock R-squared = (how a stock moves with
(asset) returns against Correlation of the the market), there are two
market returns) stock with the market key differences. The first
^2 is that the R-squared is
always a positive number
whereas the correlation
can be positive or
negative. In other words,
a high R-squared can
indicate either a stock
that moves with the
market or against it. The
second is that the R-
squared is the more
consistent number to use
when talking about
varriances whereas the
correlation coefficient is
more relevant when
talking about standard
deviations or betas.
Reinvestment Reinvestment Rate = Proportion of a firm's The reinvestment rate is
Rate (Net Capital after-tax operating the firm analog to the
Expenditures + Change income that is put equity reinvestment rate
in Non-cash Working back into the (which measures how
capiital) / EBIT (1-t) business to create much of equity earnings
future growth. is reinvested back into

55
 the business). The key
difference is that you
look at total reinvestment
rather than just the equity
portion of that
reinvestment and the
after-tax operating
income, rather than net
income.
Like the equity
reinvestment rate, this
number can be negative,
in which case the firm is
shrinking the capital
invested in the business,
or greater than 100%, in
which case it is raising
fresh capital.
Research and Operating expense item Investment in basic If we stay true to the
Development in the income statement research that may or definitiion of capital
Expenses (R&D) includes the current may not pay off as expenditures (as
year's R&D expense. products in the expenses designed to
future. generate benefits over
many years), R&D is
clearly a capital
expenditure. However,
accountants have used
the uncertainty of
potential benefits as a
rationale for expensing
the entire amount spent,
arguing that this is the
conservative thing to do.
In reality, it is not
conservative because it
also means that the
biggest asset on the
books for some
companies - money
invested in developing
new drugs in
pharmaceutical
companies or new
technolgy at technology
company - will not be on
the books. As a result, we

56
 skew upwards the return
on equity can capital
calculations for these
firms. It is best to
capitalze R&D, using an
amortizable life for
research (the expected
number of yars, on
average, between doing
R&D and a product
emerging) and R&D
expenses from the past.
Retention Ratio 1 - Dividend Payout Proportion of net The retention ratio looks
Ratio income not paid out at retained earnings in a
as dividends and firm. While analysts
invested in either often assume that these
operating assets or earnings are being
held as cash. reinvested, that
assumption does not
always hold, since the
firm may just hold cash
balances. That is part of
the reason we compute
an equity reinvestment
rate, which measures
more directly equity
investment in operating
assets (rather than cash).
The retention ratio
cannot be less than 0% or
greater than 100%.
Return on Assets EBIT (1-t)/ Book value Return generated by While some analysts use
of total assets existing assets this ratio interchangeably
with the return on capital,
there is one key
difference:
Capital Invested = Debt
+ Equity - Cash = Total
Assets - Cash - Non-debt
Current liabilities
In effect, capital invested
does not include all
assets; it explicitly
eliminates cash and
includes non-cash

57
 working capital (which is
the difference between
non-cash current assets
and non-debt current
liabilities). If you plan on
comparing a return to the
cost of capital, the more
consistent measure is the
return on invested capital
Return on Capital EBIT (1-t) / (BV of Return earned on the As with return on equity,
(ROC) Debt + BV of Equity- existing assets or we revert back to the
Cash) projects of a firm. book value of debt and
The operating income Often used as a equity in this
is usually from the measure of the computation (rather than
most recent time period quality of existing use market value)
and the numbers in the investments and because we are trying to
denominator are either compared to the cost get a sense of the returns
from the start of that of capital. that a firm is generating
period or an average on the investments it has
value over the period. already made.
Consequently, we are
assuming that the book
value of invested capital
is a good measure of
capital invested in
existing assets. This
assumption can be
violated if a firm grows
through acquisitions
(goodwill may reflect
growth assets) or takes
accounting write-offs
(thus shrinking book
capital and making
projects look better than
they really are).
Return on Equity Net Income/ Book Return earned on The book value of equity
(ROE) Value of Equity equity invested in is assumed to be a good
The net incomeis existing assets. measure of equity
usually from the most Compared to the cost invested in existing
recent time period and of equity to make assets. This assumption
the numbers in the judgments on may not be appropriate if
denominator are either whether the firm is that number is skewed by
from the start of that creating value. acquisitions (goodwill
period or an average Cannot be computed will inflate book equity)

58
 value over the period. if book equity is
(See Non-cash ROE for negative.
a variation)
Return on See Return on Capital
Invested Capital
(ROIC)
Selling, General Expense item in the
and income statement that
Administrative captures selling,
Expenses (SG&A) advertising and general
administrative costs
that cannot be directly
traced to individual
produts or services
sold.
SG&A See Selling, General
and Administrative
Expenses
Standard The standard deviation
deviation in equity in either stock returns
or ln(stock prices) over
time.
or write-offs (which tend
to deflate book equity).
If a company has a large
cash balance, the return
on equity will be affected
by its presence. The
denominator will include
the cash balance and the
numerator wil include the
income from that cash
balance. Since cash
usually earns low, close
to riskless rates, the
return on equity will drop
because of the presence
of cash.
Indirect or allocated Selling, general and
cost in a company. administrative costs is a
Comparing across loosely defined pot
companies (as a ratio where accountants tend
of sales) may provide to throw in whatever
an indicator of costs they cannot fit into
corporate bloat and conventional line items.
efficiency. This makes comparisons
across companies
difficult to do. If you
view these costs as fixed
and all other operating
costs as variable, this
may be useful in
computing operating
leverage, but that is a
strong assumption.
Variation in the For traded stocks, this
market's estimate of can be computed fairly
the value of the easily with two caveats.
equity in a firm over The first is that the
time. standard deviation
obtained will reflect the
59
 time intervals for the
returns; in other words,
the standard deviation in
weekly stock returns will
be a weekly standard
deviation. It can be
annualized by
multiplying by the square
root of 52. The second is
that the standard
deviations obtained over
a period of time are still
historical standard
deviations and may not
be appropriate forward
looking estimates for
firms that have changed
their business mix or
financial leverage.
Standard Standard deviation in Variation in the Since debt is often not
deviation in firm total firm value (market market's estimate of traded and equity is, at
value value of debt plus the value of the least for publicly traded
equity) assets (existing and firms, this number is
growth) owned by usually obtained by
the firm over time. adding the book value of
debt to the market value
of equity each period and
then computing the
standard deviation in the
combined value over
time; you can either
compute the percentage
change in value each
period or use the
ln(value). An alternative
approach is to use the
standard deviations in
stock and bond prices (if
both the stock and the
bonds are traded) and to
take a weighted average
of the two (allowing for
the covariance between
the two).
Tax Rate See Effective Tax Rate

60
(Effective)
Tax Rate See Marginal Tax rate
(Marginal)
Total Beta Total Beta = Market Relative volatility or The total beta computes
Beta / Correlation standard deviation of the risk of an asset, based
between stock and an investment on the assumption that
market (relative to the investors in that asset are
This measure is market) exposed to all risk in the
equivalent to dividing asset rather than just the
the standard deviation non-diversifiable or
of a stock by the market risk.
standard deviation of
the market. For an
undiversified investor,
it may be a better
measure of risk than the
traditional market beta.
Unlevered Beta Unlevered Beta = Beta of the assets or The unlevered beta for a
Levered Beta / (1 + (1- businesses that a firm firm reflects the beta of
tax rate) (Debt/Equity is invested in. As a all of the investments that
Ratio)) consequence, is also a firm has made
often labelled as the (including cash). If this is
asset beta of a firm. obtained from a
regression of the stock
against the market, it will
reflect the business mix
over the period of the
regression. If it is
computed based upon the
business mix of the
company (see Bottom-up
Beta), you gain much
more flexibility. This is
the appropriate number
to start with if you are
trying to estimate a cost
of equity for use with net
income (which includes
the income from cash).
Unlevered beta Unlevered Beta/ (1 - Beta of operating This unlevered beta
corrected for cash Cash/ (Market Value of assets that a firm is reflects only the
Equity + Market Value invested in. We are operating assets of the
of Debt))) excluding cash and firm. It is the appropriate
assuming that the number to use (as a
beta of cash is zero. starting number) if you

61
 are trying to compute a
cost of equity for a cost
of capital computation.
Value/ Book (Market Value of Market's assessment The key difference
Equity + Market Value of the value of the between this multiple and
of Debt)/ (Book value assets of a firm as a the EV/Invested Capital
of Equity + Book Value multiple of the multiple is that cash is
of Debt) accountant's estimate incorporated into both
See Enterprise Value/ of the same value. the numerator and
Invested Capital denominator. If we make
the assumption that a
dollar in cash trades at
close to a dollar, this will
have the effect of
pushing Value/Capital
ratios closer to one than
EV/Invested Capital.
Value/EBITDA See Enterprrise
Value/EBITDA
Value/Sales See Enterprise
Value/Sales
Variance in equity Standard deviation in Variation over time Variance in equity value
values equity value^2 in market value of is usually computed
(See Standard deviation equity using either returns or the
in equity value) ln(price). The variance, if
computed with weekly or
monthly returns, can be
annualized by
multiplying by 52 or 12.
Variance in firm Standard deviation in Variation over time Since the market value of
values firm value^2 in market value of debt is usually difficult to
(See Standard deviation firm (debt + equtiy) obtain, analysts often use
in firm value) book value of debt in
conjunction with the
market value of equity to
obtain firm value over
time.

62