Citibank: basic of corporate finance
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Market Value Ratios
Market view of
past and future
performance
Market Value Ratios relate the company's stock price data with the
earnings and capital structure of the company. This information gives
the analyst an idea of the view investors have of the company's past
performance and also their view of the firm's future prospects. These
ratios include:
• Price / Earnings Ratio
• Market / Book Ratio
Price / Earnings Ratio
Amount investors
will pay per
dollar of profit
Price / Earnings (P/E) Ratio shows how much investors are willing
to pay for every dollar of the company's reported profits. It is calculated
by dividing the market price per share of Common Stock by EARNINGS PER
SHARE (EPS). The earnings per share calculation is NET INCOME
AVAILABLE TO COMMON divided by the Number of Shares Outstanding. The
Number of Shares can be found next to the COMMON EQUITY figure on the
Balance Sheet. Be sure to check the units on the Number of Shares; they
may not always be the same as the other figures on the Balance Sheet. On
XYZ Corporation's Balance Sheet, all figures are in millions.
Earnings per share = (Net Income to Common) / (Number of shares)
= ($6.2) / (8.0 shares)
= $0.775 per share
For our XYZ Corporation example, if the price of XYZ stock is
$12.70 per share, the P/E Ratio is:
Price / Earnings = (Market price per share) / (Earnings per share)
= ($12.70) / ($0.775)
= 16.4 times
The P/E Ratio indicates that the common shares are selling for 16.4
times the EARNINGS of XYZ Corporation.
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Market / Book Ratio
Amount investors
will pay relative
to value on books
The Market / Book Ratio shows how much investors are willing to pay
relative to the value of the company as shown on its books. The total
market value of a company is the value that investors in the stock market
(where the shares are being traded) think the company is worth. This
value is derived from the stock price at which the shares are trading. For
example, the market value for XYZ Corporation is $101.6 million (8
million shares times $12.70 per share).
To calculate the Market / Book Ratio, the analyst must first compute
the book value per share. This computation is the value of COMMON
EQUITY divided by the Number of Shares.
Book value per share = (Common Equity) / (Number of shares)
= ($105.8) / (8.0 shares)
= $13.225 per share
The Market / Book Ratio is calculated by dividing the market price per
share by the book value per share.
Market / Book = (Market price per share) / (Book value per share)
= ($12.70) / ($13.225)
= 0.96 times
The Market / Book Ratio indicates how many times above (or below) the
book value of the company investors are paying for an equity position. In
our XYZ Corporation example, investors are not quite willing to pay the
book value for the equity of the company. (1.00 times means that the
market price and the book price are the same.)
Using Ratios
The ratios we have just studied provide the analyst with information
about a company's liquidity, asset management, debt management, and
profitability. They also indicate how market investors value the
company's efforts. These ratios also provide additional insights when
compared to the ratios of other companies and when trends are
mapped over a period of time.
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Industry
comparisons
An astute analyst will first calculate a company's ratios and then make
comparisons with other similar companies in that industry or with the
industry as a whole. Any significant discrepancies will signal the
analyst that closer inspection may be needed.
For example, if most of the industries competing with XYZ Corporation
have Profit Margin Ratios of over 4% and XYZ has a Profit Margin
Ratio of 2.16%, the analyst will begin to look for reasons why XYZ is
performing so poorly. It is important to compare companies within the
same industry to gain useful observations. An automobile manufacturer
will have a much different structure than a consulting company.
Trend analysis
Trend analysis can also provide insights into the conditions of a
company. By calculating ratios over a period of several years, an
analyst can uncover potential problems within the firm.
For example, if XYZ Corporation has an Inventory Turnover Ratio of
3.24 times in 1993, 3.86 times in 1992, and 4.56 times in 1991, an
analyst will begin to look for reasons why it is taking longer for XYZ
Corporation to sell its products. These trends give clues as to whether
the financial condition is improving or deteriorating. By using industry
comparisons and trend analysis, the analyst can focus the investigation
on areas of a company that may need attention.
UNIT SUMMARY
In this unit, we discussed the three types of financial statements:
• Balance Sheet – a snapshot of conditions at a specific point
in time
• Income Statement – a summary of the operations of the
company and its profitability over a given period of time
• Cash Flow Statement – a summary of the sources and uses of
funds
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We also described the most common financial ratios:
• Liquidity Ratios
Current
Quick (Acid-Test)
• Asset Management Ratios
Inventory Turnover
Average Collection Period
Fixed Assets Turnover
Total Assets Turnover
• Debt Management Ratios
Total Debt to Total Assets
Times Interest Earned (TIE)
Fixed Charge Coverage
• Profitability Ratios
Profit Margin
Basic Earnings Power
Return on Total Assets
Return on Common Equity
• Market Value Ratios
Price / Earnings
Market / Book
Combining ratio analysis with financial statement analysis provides the
analyst with a set of tools to begin to understand how a company
operates, how it generates cash flow, and how the company compares
to competitors in the industry. These tools will assist the analyst in
finding the areas of a company that need attention and management
consideration.
You have completed Unit One: Financial Statement Analysis. Please complete Progress
Check 1.4, then continue to Unit Two: Financial Markets and Interest Rates. If you answer
any questions incorrectly, please review the appropriate text.
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4 PROGRESS CHECK 1.4
Directions: Use the following Balance Sheet and Income Statement to answer the
questions about financial ratios.
Fruit Packing, Inc. – Balance Sheet
December 31, 1993 (In Millions $)
ASSETS LIABILITIES AND EQUITY
Cash 7.4 Accounts Payable - Fruit 10.2
Marketable Securities 0.6 Accounts Payable - Material 9.6
Accounts Receivable 23.7 Notes Payable 23.0
Raw Goods Inventory 19.5 Accrued Wages and Taxes 1.7
Finished Goods Inventory 22.4 Other Current Liabilities 0.6
Prepaid Expenses 1.5 Total Current Liabilities 45.1
Other Current Assets 0.8
Total Current Assets 75.9 Long-term Debt 45.1
Preferred Stock 7.8
Gross Fixed Assets 101.2 Total Long-term Liabilities 98.0
Less Depreciation 19.9
Net Fixed Assets 81.3 Common Stock (6.5 Mil. Outst.) 15.1
Retained Earnings 44.1
Total Common Equity 59.2
Total Assets 157.2 Total Liabilities and Equity 157.2
Fruit Packing, Inc. – Income Statement
December 31, 1993 (In Millions $)
Net Sales 150.6
Operating Expenses
Depreciation
101.2
3.1
EBIT
Interest Expense
46.3
11.5
Earnings Before Taxes
Taxes (@ 40%)
34.8
13.9
Net Income to Shareholders
Preferred Dividends
20.9
6.3
Net Income to Common
Common Dividends
14.6
12.0
Earnings Retained 2.6
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PROGRESS CHECK 1.4
(Continued)
For each question, decide which ratio is appropriate and use it to calculate the answer. Mark
the correct answer and indicate which ratio you used. Check your solution with the Answer
Key on the following page.
12. How many times can Fruit Packing, Inc. pay off CURRENT LIABILITIES without relying
on INVENTORIES?
____ a) 0.75 times
____ b) 1.19 times
____ c) 1.25 times
____ d) 1.68 times
____ e) 1.80 times
Ratio:______________________________________________
13. How many times did Fruit Packing, Inc. sell out and restock its merchandise?
____ a) 2.00 times
____ b) 2.29 times
____ c) 3.59 times
____ d) 6.72 times
____ e) 7.72 times
Ratio:______________________________________________
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ANSWER KEY
12. How many times can Fruit Packing, Inc. pay off CURRENT LIABILITIES without relying
on INVENTORIES?
a) 0.75 times
Quick Ratio = (Current Assets - Inventories) / (Current Liabilities)
= ($75.9 - $19.5 - $22.4) / ($45.1)
= 0.75 times
Subtract both Raw and Finished Goods Inventory
13. How many times did Fruit Packing, Inc. sell out and restock its merchandise?
c) 3.59 times
Inventory Turnover = (Sales) / (Inventories)
= ($150.6) / ($19.5 + $22.4)
= 3.59 times
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PROGRESS CHECK 1.4
(Continued)
14. What percent of Fruit Packing, Inc.'s capital structure is provided by debt?
____ a) 27.23%
____ b) 28.69%
____ c) 43.32%
____ d) 57.38%
____ e) 62.34%
Ratio:______________________________________________
15. What percentage of each dollar from SALES is available for common shareholders?
____ a) 4.18%
____ b) 9.69%
____ c) 13.21%
____ d) 22.05%
____ e) 29.68%
Ratio:______________________________________________
16. If Fruit Packing, Inc.'s stock price is $15.24 per share and there are 6.5 million shares
outstanding, how much are investors willing to pay for every dollar of reported
profits?
____ a) 2.09 times
____ b) 2.34 times
____ c) 4.98 times
____ d) 6.78 times
____ e) 8.12 times
Ratio:______________________________________________
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