Financial Glossary
Plain-English definitions for the financial terms used throughout Watson's. New to investing? Start here.
Alpha (α)
Excess returnHow much the expected return exceeds (or falls short of) the minimum required return.
Formula
Alpha = Expected Return − Required Return
(Required Return = Cost of Equity from CAPM)What to plug in
Required return is the cost of equity (Risk-Free Rate + Beta × ERP, plus any premiums). Expected return is what your DCF or scenario model implies — usually computed as IRR from current price to projected exit price.
Why this matters
Alpha is the active manager's scoreboard. Positive alpha means the position is expected to beat what its risk warrants; negative alpha means even if you're right, you're not being paid enough for the risk. The whole goal of stock-picking is to find positive alpha. Note: alpha measured ex-post (after the fact) is different from ex-ante alpha (forecasted) — most "alpha" disappears once trading costs and tax drag are subtracted.
Beta (β)
Market sensitivityHow much a stock moves relative to the overall market. A beta of 1.0 means it moves with the market.
Formula
β = Covariance(Stock Returns, Market Returns) ÷ Variance(Market Returns)
(Slope of a regression of stock returns on market returns)What to plug in
Use 2-5 years of weekly or monthly returns regressed against the S&P 500 (or a relevant market index). Most data providers (Yahoo, Bloomberg) publish a 5-year monthly beta. For thinly traded stocks, betas are noisy — consider using an industry-average beta instead.
Why this matters
A beta of 1.0 means the stock moves with the market on average; 1.5 means a 10% market drop tends to coincide with a 15% stock drop; 0.5 means the stock moves only half as much. Tech and high-growth names typically have betas of 1.2-1.8, utilities and consumer staples 0.4-0.8. Beta drives the cost-of-equity input in CAPM, so getting it wrong propagates through the whole DCF.
Buyback Rate
Share repurchase rateThe annual percentage by which a company reduces its share count through stock buybacks. Fewer shares means each remaining share is worth more.
Formula
Buyback Rate = (Shares Repurchased ÷ Beginning Shares Outstanding) × 100
Or equivalently: Buyback Yield = Cash Spent on Buybacks ÷ Market Cap × 100What to plug in
From the cash flow statement: "Repurchase of Common Stock" gives gross buybacks. Subtract any new share issuance (mostly from stock-based compensation) to get the NET reduction in share count. A company can spend $5B on buybacks but issue $4B in new SBC shares — net buyback is only $1B.
Why this matters
Buybacks are mathematically equivalent to a special dividend, but with two advantages: (1) they're tax-efficient (no tax until you sell), and (2) the remaining shares each own a bigger slice of the same business, mechanically increasing EPS. Watch for the "buyback at any price" trap: a company buying back stock at peak valuations destroys value, while buying at depressed prices creates real value. Best buybacks happen during downturns — most actually happen during upturns when CFOs feel rich.
CAGR
Average yearly growth rateCompound Annual Growth Rate — the smoothed annual growth rate over a period, as if growth were perfectly steady each year.
Formula
CAGR = (Ending Value ÷ Beginning Value)^(1 ÷ Number of Years) − 1What to plug in
Pick a starting period and an ending period (e.g., revenue 5 years ago vs. revenue today). The formula assumes steady compounding — the final number is what one constant growth rate would have produced over those years.
Why this matters
CAGR strips out the year-to-year noise to show long-run growth. Useful because raw growth rates are misleading: a company that grew 50% one year and -20% the next had a 5Y CAGR of about 9.5%, not 15% (the simple average). The big caveat: CAGR averages away volatility, so two stocks with identical CAGRs can have wildly different actual paths — one steady, one wild. Always pair CAGR with a volatility measure when comparing investments.
Correlation (ρ)
How factors move togetherMeasures whether two things tend to rise and fall together (positive) or move in opposite directions (negative).
Formula
ρ(X, Y) = Cov(X, Y) ÷ (σₓ × σᵧ)
(Correlation = Covariance ÷ product of standard deviations)
Range: −1 to +1What to plug in
Use historical time series of the two variables (e.g., monthly revenue growth and margin changes over 5 years). Correlations move with the regime — what was true in 2010-2020 may not hold in 2020-2030.
Why this matters
Correlation matters because diversification only works when correlations are below 1. Two stocks with 0.95 correlation are almost the same bet; two with 0.3 correlation actually diversify each other. In a Monte Carlo, ignoring correlation between inputs (e.g., treating revenue growth and margin as independent when they're actually correlated) produces wrong tail-risk estimates. Crisis-era correlations spike toward 1 — "all correlations go to one in a crash" — which is when diversification fails most.
Cost of Debt (Kd)
After-tax borrowing rateThe effective annual interest rate the company pays on its debt, after the tax savings from interest deductibility.
Formula
After-Tax Cost of Debt = (Interest Expense ÷ Total Debt) × (1 − Tax Rate)
Or if bonds trade publicly: Cost of Debt = Bond Yield to Maturity × (1 − Tax Rate)What to plug in
Use TTM interest expense divided by average total debt for a rough pre-tax rate, then multiply by (1 − effective tax rate). Or use the yield-to-maturity on the company's outstanding bonds if available — that's the market's view of credit risk in real time.
Why this matters
Debt is almost always cheaper than equity because lenders sit ahead of shareholders in bankruptcy and interest is tax-deductible. The after-tax adjustment captures the "interest tax shield" — at a 21% corporate tax rate, a 5% pre-tax loan effectively costs 3.95%. This is the floor for any project: if it can't return more than the cost of debt, even debt-financed growth destroys shareholder value.
Cost of Equity (Ke)
Return stockholders expectThe annual return shareholders expect for the risk of owning this stock instead of a safe bond.
Formula
Ke = Risk-Free Rate + Beta × Equity Risk Premium
(Capital Asset Pricing Model — CAPM)
Optional add-ons: + Country Risk Premium + Size PremiumWhat to plug in
Risk-free rate = 10-year US Treasury yield (currently around 4-4.5%). Equity risk premium ≈ 5% historical average. Beta from a regression of stock returns on market returns over 2-5 years. For non-US companies add a country risk premium; for sub-$10B market caps consider a size premium.
Why this matters
Cost of equity captures what return stockholders need to be compensated for taking equity risk instead of buying Treasuries. It's always higher than the cost of debt because shareholders are last in line if the company goes bankrupt. Typical values: 7-9% for stable mega-caps (KO, JNJ), 10-12% for cyclicals or mid-caps, 13%+ for high-beta growth names. CAPM is the textbook approach but has known weaknesses — Damodaran calls it "the worst possible cost-of-equity model, except for all the others."
Country Risk Premium
Extra return for country riskAdditional required return for investing in markets outside the developed world — captures political, institutional, and currency risk.
Formula
Country Risk Premium ≈ Sovereign Bond Spread × (Equity Volatility ÷ Bond Volatility)
(Damodaran method; simpler approaches use the sovereign CDS spread directly)What to plug in
Look up the sovereign bond yield spread between the country in question and US Treasuries (or Germany for European calculations). Aswath Damodaran of NYU publishes updated country risk premiums every January at pages.stern.nyu.edu/~adamodar.
Why this matters
Investing in Brazil, Turkey, or Indonesia carries political, currency, and institutional risk that doesn't exist in the US, UK, or Germany. The country risk premium adds a top-up to required returns for emerging-market investments. Typical numbers (rough): US 0%, Brazil 3-5%, Turkey 6-9%, frontier markets 10%+. For a US-only DCF, leave this at 0.
Current Ratio
Short-term liquidityWhether the company has enough liquid assets to cover its bills due in the next year.
Formula
Current Ratio = Current Assets ÷ Current LiabilitiesWhat to plug in
From the balance sheet. "Current" = anything maturing or convertible within 12 months — cash, receivables, inventory on the asset side; payables, short-term debt, accrued expenses on the liability side.
Why this matters
A quick liquidity check. Above 1 means the company can theoretically pay near-term bills from current assets; below 1 means it depends on rolling debt or selling longer-term assets to stay solvent. But context matters: retailers like Walmart routinely run below 1 because they're net working-capital positive (collect from customers before paying suppliers) — that's a strength, not a weakness.
DCF
Cash flow valuationValues a company by estimating all future cash it will generate and discounting it back to today's dollars.
Formula
Enterprise Value = Σ FCFₜ ÷ (1 + WACC)ᵗ + Terminal Value ÷ (1 + WACC)ⁿ
Terminal Value = FCFₙ × (1 + g) ÷ (WACC − g)
Equity Value = Enterprise Value − Net Debt
Fair Price = Equity Value ÷ Diluted SharesWhat to plug in
Project FCF for years 1-5 (near-term growth) and 6-10 (fade rate); pick a terminal growth rate ≤ risk-free rate; discount everything by WACC. Default forecast in this model: 8% near-term FCF growth, 5% fade-down, 2.5% terminal growth.
Why this matters
DCF is the foundational valuation method — every other method is a shortcut for it. The strength is that it's anchored in fundamentals (cash flows, growth, risk); the weakness is that it's extremely sensitive to assumptions, especially WACC and terminal growth. A 100bp change in WACC can swing fair value 15-20%. The terminal value usually accounts for 60-80% of the total — so the assumption you're least sure about (long-run growth) drives most of the answer. Treat DCF outputs as a range, not a point estimate.
Debt-to-Equity
Borrowing levelHow much debt a company uses compared to shareholder equity. Higher means more borrowed money, which adds risk but can boost returns.
Formula
Debt-to-Equity = Total Debt ÷ Total Shareholder EquityWhat to plug in
Total debt (short-term + long-term) and total equity from the latest balance sheet. Some analysts use only long-term debt; others include operating leases (since ASC 842, leases sit on the balance sheet anyway). For valuation/WACC purposes, market values are preferable to book values when available.
Why this matters
Tells you the capital structure. A D/E of 0 means an all-equity company; 1.0 means equal debt and equity; 3.0 means three times more debt than equity (highly leveraged). Healthy public companies typically run 0.3-1.0; utilities and REITs run higher (1-2x); tech companies often run near 0. Higher D/E magnifies returns when things go well and accelerates losses when they don't — which is why debt-heavy companies have higher betas and higher costs of equity.
Dividend Yield
Annual cash payout rateThe percentage of the stock price paid out as dividends each year. Like interest on a savings account, but for stocks.
Formula
Dividend Yield = Annual Dividend per Share ÷ Current Share Price × 100What to plug in
Use the most recently announced annual dividend (or four times the latest quarterly dividend for an indicative annualized figure) divided by the current share price. The "trailing yield" uses dividends actually paid in the last 12 months; the "forward yield" uses the expected next 12.
Why this matters
A direct comparison to bond yields. A 4% dividend yield is meaningful when 10-year Treasuries yield 4-5%, less so when bonds yield 7%. But dividend yield alone misses two things: (1) buybacks — many tech companies return more cash via buybacks than dividends would (see Shareholder Yield); (2) sustainability — a 10% dividend yield is often a warning that the market expects a dividend cut. Always check the payout ratio (dividends ÷ earnings) — anything above 60-70% is fragile.
Earnings Beat Rate
Frequency of beating estimatesThe percentage of recent quarters in which the company beat analyst consensus EPS estimates.
Formula
Beat Rate = (Quarters with Actual EPS > Consensus Estimate) ÷ Total Quarters × 100What to plug in
Look at the most recent 4-12 quarters. Most US large-caps beat consensus ~65-75% of the time — that's how the analyst-guidance game is played: companies guide expectations down ahead of the print, then beat them slightly.
Why this matters
Less informative than people think. A high beat rate is mostly evidence of skilled investor-relations and conservative guidance, not exceptional business performance. The interesting signal is the opposite: companies that miss frequently are often in genuine trouble. Pair with the magnitude of beats/misses (EPS Surprise %) — small beats with shrinking margins is bearish even if the headline number beats.
EPS (Diluted)
Earnings per shareHow much profit the company makes for each share of stock. "Diluted" counts all potential shares (including options).
Formula
Diluted EPS = Net Income ÷ Diluted Weighted-Average Shares OutstandingWhat to plug in
Use net income from the income statement (TTM for the cleanest read) and diluted weighted-average shares (not basic). Diluted assumes all options, warrants, and convertibles are exercised at fair value.
Why this matters
EPS is the building block of P/E and most per-share valuation work. Be careful with two things: (1) GAAP vs. non-GAAP — companies report both, with non-GAAP typically excluding stock-based compensation, restructuring, and other "one-time" items, often making earnings look 20-50% better than reality. (2) Share count — if EPS grows 10% but diluted shares drop 3% from buybacks, only 7% of the EPS growth came from actual business performance.
EPS Surprise
Beat or miss sizeThe percentage difference between the EPS the company actually reported and what analysts expected.
Formula
EPS Surprise % = (Actual EPS − Consensus Estimate) ÷ |Consensus Estimate| × 100What to plug in
Use the consensus EPS estimate immediately before the earnings release (the "pre-print" number) and the actual reported EPS.
Why this matters
Stock prices often react more to the size and direction of the surprise than to absolute EPS. A small beat (1-3%) is the norm and barely moves the stock. A 10%+ beat usually triggers a positive move and analyst upgrades; a miss of any size often triggers selling. Watch for "whisper numbers" — informal buy-side expectations that often run above published consensus, so a stock can beat consensus but miss the whisper and still drop.
Equity Risk Premium
Extra return for stock riskThe extra return investors demand for choosing stocks over risk-free government bonds.
Formula
ERP = Expected Market Return − Risk-Free RateWhat to plug in
Two flavors: (1) historical ERP — average annual outperformance of stocks vs Treasuries over 1928-present, ≈ 5-7%; (2) implied ERP — solve for the discount rate that justifies current S&P 500 prices given consensus earnings estimates, currently ≈ 4-5%. Damodaran's monthly implied ERP is the buy-side standard.
Why this matters
ERP is the most consequential single input in the entire DCF model — small changes drive big valuation changes. It's also the most subjective: there's no objectively correct number. Most institutional models use 5-6%. A higher ERP (7%+) implies you think future stock returns will be lower than the historical average; a lower ERP (3-4%) implies you think current prices are reasonable. The 4-5% you see today is markedly lower than the 6-7% that prevailed before 2010.
EV/EBITDA
Enterprise value per operating profitCompares a company's total value (including debt) to its operating profits, useful for comparing companies with different debt levels.
Formula
EV/EBITDA = Enterprise Value ÷ Trailing EBITDA
EV = Market Cap + Total Debt − Cash & Equivalents
EBITDA = Earnings Before Interest, Taxes, Depreciation, and AmortizationWhat to plug in
Use TTM EBITDA from the income statement. EV = current market cap + total debt − cash from the latest balance sheet. EBITDA is operating income before non-cash charges and financing decisions, so it lets you compare across capital structures.
Why this matters
The most-used multiple in M&A and private-equity work because it's capital-structure-neutral — a debt-heavy and a debt-light competitor can be compared head-to-head. But EBITDA flatters capital-intensive businesses by ignoring their actual capex needs. For a software company with low capex, EV/EBITDA ≈ EV/FCF; for a telecom or airline with massive capex, EBITDA can be 2-3x bigger than FCF, making the multiple look misleadingly cheap. Always cross-check with EV/FCF for capex-heavy businesses.
EV/FCF
Enterprise value per dollar of cash flowHow many years of free cash flow it would take to pay back the entire enterprise (equity + debt). One of the cleanest "is this cheap?" reads.
Formula
EV/FCF = Enterprise Value ÷ Trailing Free Cash Flow
Free Cash Flow = Operating Cash Flow − Capital ExpendituresWhat to plug in
Use TTM free cash flow from the cash flow statement (operating cash flow minus CapEx). Some analysts subtract stock-based compensation from FCF for a stricter view; others don't.
Why this matters
Often more reliable than EV/EBITDA because EBITDA ignores the real cash drain of capex — fine for asset-light software, misleading for capital-intensive industries (telecom, airlines, semis). Mature cash-cow businesses (Coke, P&G) typically trade at 18-25x EV/FCF; high-growth at 30x+.
EV/Sales
Enterprise value per dollar of salesLike P/S but uses Enterprise Value (which includes debt) instead of just market cap. Captures the full cost of buying the business.
Formula
EV/Sales = Enterprise Value ÷ Trailing Revenue
EV = Market Cap + Total Debt − Cash & EquivalentsWhat to plug in
Use TTM revenue, current market cap, total debt and cash from the latest balance sheet. EV/Sales is the standard multiple in M&A because an acquirer must pay off the debt too — so debt-heavy companies look cheaper on P/S than they really are.
Why this matters
A company with $1B market cap and $2B debt has the same revenue as a debt-free $1B competitor — but it costs $3B to acquire, not $1B. EV/Sales captures that distinction. It's also cleaner than EV/EBITDA when EBITDA is volatile or negative.
Exit Multiple
Future valuation multipleThe P/E or EV/EBITDA ratio you expect the stock to trade at when you sell. Think of it as how much investors will pay per dollar of future earnings.
Formula
Implied Exit Price = Year-N EPS × Exit P/E
(Or: Exit Enterprise Value = Year-N EBITDA × Exit EV/EBITDA)What to plug in
For the bear scenario, use a multiple at the low end of the company's 10-year range or below industry peers. For base, use the long-run average. For bull, the high end — but be skeptical of "highest ever" multiples persisting forever. Mature businesses tend to mean-revert toward 14-18x P/E over long periods.
Why this matters
Multiples-based valuation says: "the future price is whatever the future earnings × the multiple investors will pay then." The exit multiple is your assumption about that future appetite. Two stocks with identical earnings forecasts can have very different fair values if one's exit multiple is 12x and the other's is 30x. The honest approach is to use a multiple consistent with the business's long-term fundamentals (growth, margins, capital intensity) — not a hopeful number that requires multiple expansion to make the math work.
FCF Margin
Cash marginWhat percentage of revenue converts to actual cash after paying for operations and capital investment.
Formula
FCF Margin = Free Cash Flow ÷ Revenue
Free Cash Flow = Operating Cash Flow − CapExWhat to plug in
Use TTM operating cash flow and TTM capital expenditures from the cash flow statement, then divide by TTM revenue.
Why this matters
The single best read on earnings quality. If FCF margin is consistently higher than net margin, the company converts profits to cash well — that's a sign of low working-capital needs or favorable timing. If FCF margin is consistently lower, watch out for aggressive accounting or heavy capital intensity that the income statement is hiding. Best-in-class businesses (mature software, payment networks) run FCF margins of 25-40%.
FCF Yield
Cash flow return on priceHow much cash the company generates each year, as a percentage of what you'd pay to own all of it. The cash-flow equivalent of earnings yield.
Formula
FCF Yield = Free Cash Flow ÷ Market Cap × 100
(Per-share form: FCF per Share ÷ Share Price)What to plug in
TTM free cash flow (operating cash flow minus capex) divided by current market cap. Some analysts prefer using enterprise value in the denominator (FCF Yield on EV) to account for debt — that's a slightly stricter measure.
Why this matters
A direct comparison to bond yields. If FCF yield is 6% and 10-year Treasuries pay 4%, you're getting a 200-bp risk premium for the equity risk. Generally 5%+ is attractive, 8%+ is rich, 3% or lower means investors are paying for future growth. Mature cash-cow businesses tend to deliver 4-7% FCF yield steadily.
Free Cash Flow
Cash left after expensesCash generated by the business after paying for operations and investments. This is money available to return to shareholders or reinvest.
Formula
Free Cash Flow = Operating Cash Flow − Capital Expenditures
(Sometimes also subtract: stock-based compensation, working-capital changes, lease payments — depending on definition)What to plug in
Operating cash flow and capex from the cash flow statement (TTM). Be aware: some analysts subtract stock-based compensation (which is a non-cash expense but represents real dilution), giving "FCF after SBC" — a stricter measure that's 10-30% lower for tech companies.
Why this matters
FCF is the closest thing to "real" earnings. Net income includes non-cash charges (depreciation, amortization, stock-based comp) and accruals that can swing it; FCF is actual money in the bank. The most reliable companies grow FCF faster than net income over time. A persistent gap where net income is much higher than FCF often signals aggressive accounting, while FCF higher than net income is usually a positive (think mature businesses with high depreciation).
Gross Margin
Profit after direct costsWhat's left from each dollar of revenue after paying the direct cost of producing the product or delivering the service.
Formula
Gross Margin = (Revenue − Cost of Goods Sold) ÷ RevenueWhat to plug in
From the income statement. "COGS" for product companies, "cost of revenue" for software and services. Use TTM (trailing 12-month) figures for the cleanest read.
Why this matters
The first and most direct read on pricing power. Software companies typically run 70-90% (one extra customer is almost free), branded consumer goods 40-60%, commodity manufacturers 15-25%, grocers 20-30%. Rising gross margin signals pricing power or favorable mix; falling margin signals competition or input cost pressure. A durable, slowly-rising gross margin is one of the strongest signs of a moat.
Interest Coverage
Ability to pay debt interestHow many times over the company can pay its annual interest expense from operating profit. The credit-rating community's favorite leverage check.
Formula
Interest Coverage = EBIT ÷ Interest Expense
(EBIT = Operating Income; or Earnings Before Interest and Taxes)What to plug in
Operating income (EBIT) and interest expense, both from the income statement. Use TTM. Some analysts swap in EBITDA for a more generous version (EBITDA Coverage).
Why this matters
Below 1.5x is dangerous — any meaningful earnings dip and the company can't service its debt. Between 1.5x and 3x is leveraged, common in private-equity-backed businesses. Above 5x is comfortable. Above 10x means debt is essentially trivial. This is the metric that gets a company downgraded by S&P or Moody's when it falls.
Justified P/E
Fair price-to-earningsThe P/E ratio a stock deserves based on its growth, profitability, and risk — not just what the market pays.
Formula
Justified P/E = (1 − Growth/ROE) ÷ (Cost of Equity − Growth)
(Gordon Growth model rearranged for P/E)What to plug in
Use long-run sustainable growth (g), ROE, and cost of equity (Ke). The formula assumes the company can sustainably generate the inputs you give it — garbage in, garbage out. Useful as a sanity check rather than a precise number.
Why this matters
Anchors what P/E "should" be given the company's fundamentals. If a stock trades at 30x P/E but its justified P/E is 18x, the market is paying a 65% premium versus what growth and quality alone justify. That premium might be deserved (moat, optionality) or not (hype). The model is most reliable for steady-state mature businesses; for fast-growers it's less useful because their growth rates aren't sustainable.
Market Cap
Total company valueThe total value of all a company's shares. Calculated as share price times the number of shares outstanding.
Formula
Market Cap = Current Share Price × Diluted Shares OutstandingWhat to plug in
Use the latest share price and diluted share count (which includes options and convertibles, not just basic shares). Float-adjusted market cap subtracts insider-held shares — useful for index inclusion analysis but rarely needed for valuation work.
Why this matters
Market cap is the equity-side value of the company — what shareholders own. Enterprise value (market cap + debt − cash) is the whole-business value. Mega-cap (>$200B), large-cap ($10-200B), mid-cap ($2-10B), small-cap ($300M-2B), micro-cap (<$300M). Size matters because: (a) larger companies tend to be more diversified and less volatile, (b) institutional money is restricted to bigger names, and (c) liquidity drops sharply below $1B.
Monte Carlo
Probability simulationRuns thousands of random scenarios to show the range of possible outcomes, not just one guess.
Formula
Result Distribution = Run N simulations, each drawing random values for inputs (revenue growth, margins, multiples) from probability distributions you specifyWhat to plug in
For each uncertain input, pick a distribution (normal, lognormal, triangular) and parameters (mean, standard deviation, min/max). Then run 1,000-10,000 trials. Output is a distribution of fair values rather than a single point estimate.
Why this matters
Single-point DCFs lie about precision — every input is uncertain, but combining multiple uncertain inputs into one number hides that. Monte Carlo shows the realistic range: P5 (worst-case 5th percentile), P50 (median), P95 (best-case 5th percentile). If your "fair value" of $100 has a 5th-95th percentile range of $60 to $180, that's very different from a tight $90-$110 range — same point estimate, but very different conviction.
Net Debt / EBITDA
Years of cash flow to pay off debtRoughly how many years of operating cash flow it would take to pay off the company's debt. The standard leverage metric in credit and M&A.
Formula
Net Debt / EBITDA = (Total Debt − Cash & Equivalents) ÷ Trailing EBITDAWhat to plug in
Total debt (short-term + long-term) and cash from the latest balance sheet, divided by TTM EBITDA from the income statement.
Why this matters
The most-watched leverage ratio in credit analysis. Below 1x = clean balance sheet; 2-3x = typical for healthy public companies; above 4x = highly leveraged; 6-7x = leveraged buyout territory. Banks set debt covenants based on this ratio — if it crosses a threshold, the company can be forced to refinance on worse terms.
Net Margin
Bottom-line profit marginWhat percentage of revenue is left as profit after every cost — operations, interest, taxes, everything.
Formula
Net Margin = Net Income ÷ RevenueWhat to plug in
Use TTM net income (the bottom line of the income statement) and TTM revenue. Watch for one-time gains and losses (asset sales, restructuring charges, tax adjustments) that can distort a single quarter or year.
Why this matters
The cleanest "what's left for shareholders" number, but also the most volatile because tax rates, interest expense, and one-time items swing it. Useful for tracking the same company over time; less useful for comparing across companies with different capital structures or tax situations. Pair it with operating margin to separate operating performance from financing decisions.
Operating Margin
Profit per dollar of salesWhat percentage of revenue is left as profit after paying operating costs. Higher margins mean more efficient operations.
Formula
Operating Margin = Operating Income ÷ Revenue × 100
(Operating Income = Revenue − COGS − Operating Expenses, before interest and tax)What to plug in
Use TTM operating income and TTM revenue from the income statement. Operating income excludes interest expense, taxes, and one-time items — this isolates the underlying business performance from financing and tax decisions.
Why this matters
The cleanest read on operating efficiency, independent of capital structure or tax rates. Software companies often run 25-40% operating margins; industrials 10-20%; retailers 3-8%. Trends matter more than absolute levels — a margin that's consistently expanding signals pricing power, scale, or improving mix; declining operating margin signals competition or cost pressure that may not show up yet in revenue. Operating margin is what an acquirer or merger analyst focuses on, since post-deal it's controllable.
P/B Ratio
Price per dollar of book valueHow many dollars investors pay for each dollar of net assets on the balance sheet. Most meaningful for asset-heavy businesses like banks.
Formula
P/B = Share Price ÷ Book Value per Share (or Market Cap ÷ Total Equity)What to plug in
Book value = total shareholder equity from the latest balance sheet, divided by shares outstanding. Some analysts strip out goodwill to get tangible book value, which is stricter and more conservative.
Why this matters
P/B is the most useful for banks, insurers, and REITs — businesses where assets (loans, bonds, real estate) are mostly liquid and marked near fair value. For tech and consumer brands it's nearly useless because most of the value (code, brand, customer base) doesn't appear on the balance sheet. A P/B below 1 can signal distress or a hidden bargain — verify which by digging into the actual asset quality.
P/E Ratio
Price per dollar of earningsHow many dollars investors pay for each dollar of annual profit. Lower may mean cheaper; higher may mean more growth expected.
Formula
P/E = Share Price ÷ Earnings Per Share (EPS)What to plug in
Use the latest share price and trailing-12-month diluted EPS for a stable picture. For growth bets, swap in forward EPS (next-year analyst estimate) — the result is called Forward P/E. Always pair a P/E with the company's growth rate; a 30x P/E is cheap if earnings grow 30%/year and expensive if they're flat.
Why this matters
P/E is the simplest valuation shortcut: how many years of current profits would it take to pay back the share price? Tech and high-growth names trade at higher P/Es because investors expect earnings to be much larger in the future. Banks, utilities, and cyclicals trade at lower P/Es because earnings are sensitive to rates and the economy. Compare a stock's P/E to its own 5-year average and to industry peers — those two anchors tell you more than any absolute number.
P/FCF
Price per dollar of cash flowLike P/E but uses free cash flow instead of accounting earnings — harder to manipulate, often a more reliable indicator.
Formula
P/FCF = Market Cap ÷ Trailing Free Cash FlowWhat to plug in
TTM free cash flow (operating cash flow minus CapEx); market cap from current share price × shares outstanding. Equity-side equivalent of EV/FCF — ignore debt here.
Why this matters
Free cash flow is much harder to fake than reported earnings, so P/FCF tends to be one of the most reliable "is this cheap?" reads. A company with rising P/E but flat or falling P/FCF is often a red flag — suggests reported earnings are growing through accounting choices, not actual cash.
P/S Ratio
Price per dollar of salesHow many dollars investors pay for each dollar of annual revenue. Most useful when earnings are negative or volatile.
Formula
P/S = Market Cap ÷ Trailing-12-Month RevenueWhat to plug in
Plug in the latest market cap (current share price × shares outstanding) and TTM revenue from the income statement. For unprofitable or early-stage companies where P/E is meaningless, P/S is often the cleanest valuation read.
Why this matters
Revenue is harder to manipulate than earnings, so P/S resists accounting tricks. Sector matters enormously: software trades at 5-15x sales because margins are 30%+, grocery stores at 0.3-0.7x because margins are 1-2%. Always compare to peers in the same industry, not across industries.
Peer Multiples Valuation
Comparable-company valuationValues the company at the median multiple of similar listed peers — e.g., if peers trade at 18x earnings and this company earns $5/share, fair value is $90.
Formula
Peer Fair Value = Peer Median Multiple × Subject Company Earnings
(Multiple can be P/E, EV/EBITDA, P/S, or whichever is most relevant for the sector)What to plug in
Identify 4-6 publicly-listed peers in the same industry and similar size. Compute the median multiple (P/E for stable earners, EV/EBITDA for capex-heavy or debt-heavy businesses, P/S for unprofitable growth). Multiply by the subject company's TTM figure. Filter out ETFs, non-comparable geographies, and obvious outliers.
Why this matters
A useful sanity check on a DCF: if your DCF says $200 but five peers all trade between $100-120 with similar fundamentals, your DCF assumptions are probably too aggressive. The big caveat is that peer multiples just transmit prevailing market sentiment — if the whole sector is overvalued, your "peer fair value" will overshoot the same way. Always cross-check with a fundamentals-based DCF; never use peer multiples as the only anchor.
PEG Ratio
P/E adjusted for growthThe P/E ratio divided by the earnings growth rate. Tries to answer "is this P/E expensive once you account for how fast earnings are growing?"
Formula
PEG = P/E ÷ Earnings Growth Rate (%)What to plug in
Use forward P/E and a forward 3- to 5-year consensus EPS growth rate from analyst estimates. Peter Lynch's rule: PEG below 1.0 is potentially cheap, above 2.0 is expensive even after growth.
Why this matters
A 30x P/E sounds expensive but is actually cheap if earnings grow 40% per year (PEG = 0.75). Conversely, a 12x P/E is expensive if earnings shrink 5% per year. The catch: PEG depends entirely on analyst growth forecasts, which are systematically too optimistic — especially for high-flying names. Treat PEG as a starting point, not a verdict.
Revenue Growth (YoY)
Sales growth rateHow much faster (or slower) sales are growing this period versus the same period a year ago.
Formula
Revenue Growth = (Current Period Revenue − Prior Period Revenue) ÷ Prior Period Revenue × 100What to plug in
For TTM-on-TTM, compare the latest 12 months to the prior 12. For quarterly, compare to the same quarter last year (Q3 vs Q3) — this avoids seasonality distortion that quarter-on-quarter comparisons have.
Why this matters
Revenue is closer to ground truth than earnings — earnings can be massaged via accruals, write-offs, and tax timing, but revenue is harder to fake. Mature businesses grow 3-7% per year, healthy growers 10-20%, hyper-growth 30%+. The most important pattern to watch is decelerating revenue growth in a stock trading at a high multiple — that combination often precedes meaningful price drops.
ROE
Return on equityHow much profit a company generates with the money shareholders have invested. Higher is generally better.
Formula
ROE = Net Income ÷ Average Shareholder Equity × 100What to plug in
Use TTM net income and average equity (beginning + ending) ÷ 2 from the balance sheet. Some analysts strip out goodwill for "tangible ROE" — useful for comparing companies with very different acquisition histories.
Why this matters
ROE is the most common quality metric, but it's misleading on its own — high leverage mechanically inflates ROE because the equity denominator shrinks. A company with 25% ROE on a clean balance sheet is more impressive than 25% ROE with 5x leverage. Use the DuPont decomposition to see whether the ROE comes from margins, asset efficiency, or leverage. Buffett-quality businesses sustain 20%+ ROE without high leverage.
ROIC
Return on invested capitalHow much profit the company generates per dollar invested in the business (debt + equity). The single best read on capital allocation quality.
Formula
ROIC = NOPAT ÷ Invested Capital
NOPAT = Operating Income × (1 − Tax Rate)
Invested Capital = Total Equity + Total Debt − Cash & EquivalentsWhat to plug in
Operating income from the income statement, effective tax rate from the same; total equity, debt, and cash from the latest balance sheet. Different sources use slightly different definitions of "invested capital" — be consistent when comparing across companies.
Why this matters
The cleanest capital-allocation scorecard. Compare ROIC to WACC: if ROIC > WACC, the company creates value with every reinvested dollar; if ROIC < WACC, it destroys value. Buffett-style investors hunt for businesses with sustained ROIC above 15% and competitive moats that protect those returns. A high ROIC that's declining is often a warning sign — moats erode over time.
Shareholder Yield
Total cash returned to ownersThe total cash returned to shareholders each year — dividends + net buybacks — as a percentage of market cap.
Formula
Shareholder Yield = (Dividends Paid + Net Share Buybacks) ÷ Market Cap × 100
(Net Buybacks = Cash Spent on Buybacks − Cash Raised from Stock Issuance)What to plug in
TTM dividends paid + TTM buybacks (subtract proceeds from any new share issuance), divided by current market cap. Some calculations add debt paydown for a "total payout yield" view.
Why this matters
A more complete read on capital return than dividend yield alone, because tech and growth-oriented companies increasingly return cash via buybacks instead of dividends. A 6% shareholder yield can come from 2% dividend + 4% buyback OR 0% dividend + 6% buyback — same dollars to existing owners. High shareholder yields (5%+) often appear in mature businesses where reinvestment opportunities are limited.
Shares Outstanding
Total shares in existenceThe total number of shares the company has issued, including all potential shares from options and convertibles (diluted basis).
Formula
Diluted Shares = Basic Shares + Stock Options + Convertible Notes + Unvested RSUs
(All assuming exercise/conversion at fair value)What to plug in
Basic shares are the count actually issued and trading; diluted adds in options, warrants, and convertibles assuming they all turn into shares. Always use diluted for per-share valuation math (P/E, EPS, FCF per share) — basic understates the real share count.
Why this matters
The denominator of every per-share metric. Watch share count growth over time — if it's creeping up 3%+ per year from stock-based compensation without matching buybacks, that's silent dilution that eats existing shareholders' returns. Conversely, a steadily shrinking share count from buybacks is a tailwind for per-share metrics. The cleanest companies grow earnings per share faster than absolute earnings because the share count is shrinking.
Sigma (σ)
Uncertainty rangeA measure of how spread out results are. One sigma covers about 68% of outcomes around the average.
Formula
σ = √[ Σ(xᵢ − μ)² ÷ N ]
(Standard deviation: square root of average squared deviation from the mean)What to plug in
For a Monte Carlo simulation: pick a sigma for each uncertain input based on historical data or your subjective uncertainty. Higher sigma = more uncertainty. For stock returns, annual sigma is typically 15-30% for individual stocks, 12-15% for the S&P 500.
Why this matters
Sigma quantifies "how wrong could I be?" In a normal distribution: ±1σ covers 68% of outcomes, ±2σ covers 95%, ±3σ covers 99.7%. Two stocks with the same expected return but different sigmas have very different risk profiles — and you should be paid more for the higher-sigma one. Real-world return distributions have "fat tails" (more extreme outcomes than the normal predicts), so 2-sigma events happen more often than the math suggests.
Size Premium
Small-cap return premiumAn add-on to required returns for smaller companies, since smaller stocks have historically delivered higher returns than CAPM alone predicts.
Formula
Size Premium = Empirical adjustment based on market-cap decile
(Ibbotson/Duff & Phelps publish annual decile tables)What to plug in
Look up the size premium for the company's market-cap decile from Duff & Phelps (now Kroll) or Ibbotson data. Rough rule of thumb: mega-cap (>$10B) ≈ 0%, mid-cap ($2-10B) ≈ 0.5-1%, small-cap ($300M-2B) ≈ 1.5-2.5%, micro-cap (<$300M) ≈ 2.5-4%.
Why this matters
Smaller companies have historically returned more than what beta alone predicts, presumably because they're less diversified, less liquid, more dependent on key people, and more vulnerable to bad luck. Adding a size premium adjusts the cost of equity upward for sub-$10B companies. Note: academics debate whether the size effect has weakened since 2000 — some firms dropped it from their standard valuation models.
Spread vs Fair Value
Discount or premium to modelHow far the current share price sits above or below the model's blended fair-value estimate.
Formula
Spread = (Current Price − Fair Value) ÷ Fair Value × 100What to plug in
Use the current share price and the blended fair value output from the valuation model (the weighted combination of DCF, peer multiples, and scenario analysis).
Why this matters
A negative spread means the market is pricing the stock below what the model says it's worth — a potential opportunity. A positive spread means a premium. But before acting on either, gut-check the model assumptions: if WACC, terminal growth, or scenario weights are off, the "spread" is just a measurement of your assumption error. A 10-20% spread either way is typical model noise; 30%+ is meaningful but still requires conviction in the underlying inputs.
Terminal Growth
Long-run growth assumptionThe steady growth rate assumed for cash flows beyond the forecast period — typically near long-run GDP growth.
Formula
Terminal Value = FCF_finalYear × (1 + Terminal Growth) ÷ (WACC − Terminal Growth)
(Gordon Growth model)What to plug in
Set near long-run nominal GDP growth (2-3% in the US, lower in Japan/Europe, higher in emerging markets). Critical constraint: terminal growth must be LESS than WACC, or the math blows up to infinity. Typical default in this model: 2.5%.
Why this matters
Terminal value usually accounts for 60-80% of total DCF value, so terminal growth is the single most consequential assumption in the model. A 50bp change (2.5% → 3%) can shift fair value 10-15%. Constraint: no company can permanently outgrow the economy it operates in — if it did, eventually it would be the entire economy. So 2-3% is the realistic ceiling for nominal terminal growth in mature markets.
Unlevered Beta (βU)
Business risk without debtThe company's market sensitivity stripped of the extra volatility caused by debt. Captures the underlying business risk only.
Formula
Unlevered β = Levered β ÷ [1 + (1 − Tax Rate) × (Debt ÷ Equity)]
(Hamada equation)What to plug in
Use the company's observed levered beta (standard market beta from regression of stock returns on market returns), its effective tax rate, and current debt-to-equity ratio.
Why this matters
Useful for two things: (1) comparing the inherent business risk of companies with different capital structures, since financial leverage adds volatility on top of operating volatility; (2) "relevering" to a target capital structure — strip out the current leverage, then add back leverage at your assumed future D/E. This is how DCF models account for changing capital structure over time.
WACC
Required returnThe minimum annual return a company needs to earn to satisfy both its lenders and shareholders.
Formula
WACC = (E/V × Ke) + (D/V × Kd × (1 − Tax Rate))
E = Equity, D = Debt, V = E + DWhat to plug in
You need: cost of equity (Ke from CAPM), after-tax cost of debt (Kd), and the target capital-structure weights (debt/equity mix). Use market values, not book values, for E and D when possible. Default values in this model: Rf = 4.25%, ERP = 5%, tax rate = 21%.
Why this matters
WACC is the discount rate in DCF — every projected dollar of future cash flow gets divided by (1 + WACC) per year out. A higher WACC compresses fair value; a lower WACC expands it. Small changes matter a lot: dropping WACC from 9% to 8% on a 10-year DCF can lift the answer 15-20%. The most-asked question in valuation interviews is "if you got the WACC wrong, how much off would your fair value be?" — and the right answer is "a lot."
Weighted Fair Value
Probability-weighted price targetThe average of your bear, base, and bull fair values, weighted by how likely you think each scenario is (default: 25% bear, 50% base, 25% bull).
Formula
Weighted Fair Value = (P_bear × Price_bear) + (P_base × Price_base) + (P_bull × Price_bull)
Probabilities must sum to 1.0What to plug in
Compute the implied price under each scenario (bull/base/bear) using your assumed revenue growth, margins, and exit multiples. Assign probabilities based on your conviction. Default: 25/50/25 reflects a moderately confident base case with balanced tail risk.
Why this matters
Forces you to think probabilistically rather than picking a single point estimate. The weighted answer is rarely the most likely outcome — it's the expected value across all outcomes. A 90% chance of $100 and a 10% chance of $0 has an expected value of $90, even though $0 will never literally happen as a "$90 outcome." This is also why weighting matters: nudging the probabilities 10 points (e.g., from 25/50/25 to 30/50/20) can shift the price target several percentage points without changing any underlying fundamental view.