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The Practical Guide to Wall Street: Equities and Derivatives by Matthew Tagliani

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CHAPTER 2
Equity Fundamentals (Part 2) Financial Ratios, Valuation, and Corporate Actions

INTRODUCTION

Companies are required to disclose their financial statements to the public to ensure that existing and potential investors have sufficiently detailed and reliable information to make an informed decision whether they want to invest. However, for the most part, the individual numbers provided in each of the three statements are of limited value on their own. Is a net sales of $10 billion per year good? That depends. It certainly isn’t if the cost of goods sold is $11 billion. What about $10 billion of net sales and $1 billion of net profit? Well, maybe . . . unless there are other similar companies that earn the same $1 billion of net profit with only $5 billion of net sales, in which case the company in question would appear to be poorly run compared to its peers. The answers to these questions are important not only for present and future investors, but for the management of the company itself who are responsible for maximizing the profitability of the company for the shareholders.
Rather than examining individual data points, it is often more illustrative to compute the ratios between various elements of the financial statements. There are a number of standardized financial ratios that are used to assess factors such as the profitability, efficiency, liquidity, growth potential, and riskiness of a company. Ratios provide useful information about an individual company ...

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