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Return on Investment
Stock investing became all the rage during the late 1990s. Even tennis stars and punk rockers got into the act. Investors watched their stock portfolios and stock mutual funds skyrocket as the stock market was reaching the mania stage at the tail-end of an 18-year upswing in stocks. Investment activity in the United States is a great example of the popularity that stocks experienced during that time period. By 1999, over half of U.S. households became participants in the stock market.
Yet millions lost money when the stock market fell big time during 20002002. People invested. Yet they really didnt know exactly what they were investing in. If they had a rudimentary understanding of what stock really is, perhaps they could have avoided some expensive mistakes. Before you invest your first dollar, you need to understand the basics of stock investing.
Some of the items to look for in the statement of cash flows include:
- Positive and growing cash from operations.
- Large and growing capital expenditures meaning that the company is investing in its future.
- Repurchase of stock represented by a negative number is generally positive. Sales of stock are generally negative unless explained by rapid growth which often requires additional equity capital.
- Anegative number for net borrowings indicating a repayment of debt is generally positive. A profitable company with low financial leverage taking on some new debt may also be positive. A highly leveraged company taking on more debt can be dangerous.
Return on equity
The shareholders of a company can be thought of as having given a company capital or equity. The return on equity (ROE) is a measure of how effectively the company has managed this equity. Equity represents that portion of the companys assets that would be distributed to shareholders if the company were liquidated and all assets sold at values reflected on the companys balance sheet, so it is what the company itself and therefore the shareholders own and does not include, for instance, money loaned from a bank.
Return on investment
Since return on investment (ROI) only relates to capital provided by shareholders, it is a limited measure of management effectiveness since we also want to know how the company is performing with the other sources of money at its disposal. Return on investment shows how effective management is in utilizing money provided by the companys owners (equity) and long-term creditors.
Profitability ratios relate to how much of the revenue the company receives is being turned into profit. Gross margin shows you what percentage of each revenue dollar is left after deducting the direct costs of producing the goods or services which in turn bring in the revenue. For a services company, the most common direct costs would be employees salaries.
The money left at this stage is called gross profit. Gross margin expresses the relationship between gross profit and revenues in percentage terms. For example, a gross margin of 10% means that ten cents out of every revenue dollar are left after deducting direct costs.
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