Chapter 4 Analysis of Financial Statements 994-6 MARKET VALUE RATIOS
ROE re" ects the effects of all of the other ratios, and it is the single best accounting
measure of performance. Investors like a high ROE, and high ROEs are correlated
with high stock prices. However, other things come into play. For example,! nan-
cial leverage generally increases the ROE but also increases the! rm’s risk; so if a
high ROE is achieved by using a great deal of debt, the stock price might end up
lower than if the! rm had been using less debt and had a lower ROE. We use the
! nal set of ratios—the market value ratios, which relate the stock price to earnings
and book value price—to help address this situation. If the liquidity, asset manage-
ment, debt management, and pro! tability ratios all look good and if investors
think these ratios will continue to look good in the future, the market value ratios
will be high, the stock price will be as high as can be expected, and management
will be judged to have been doing a good job.
The market value ratios are used in three primary ways: (1) by investors when
they are deciding to buy or sell a stock, (2) by investment bankers when they are
setting the share price for a new stock issue (an IPO), and (3) by! rms when they
are deciding how much to offer for another! rm in a potential merger.4-6a Price/Earnings Ratio
The price/earnings (P/E) ratio shows how much investors are willing to pay per
dollar of reported pro! ts. Allied’s stock sells for $23.06; so with an EPS of $2.35, its
P/E ratio is 9.8#:Price/Earnings (P/E) ratio!
Price per share____Earnings per shar (^) e
! $23.06__$2.35! 9.8"
Industry average! 11.3"
As we will see in Chapter 9, P/E ratios are relatively high for! rms with strong growth
prospects and little risk but low for slowly growing and risky! rms. Allied’s P/E ratio
is below its industry average; so this suggests that the company is regarded as being
relatively risky, as having poor growth prospects, or both.
There is no “correct” P/E ratio; but the S&P 500’s historical average is 15.9#,
and it has ranged from 48.1# to 7.1# over the last 30 years. In the winter of 2008,
the S&P’s ratio was 21.7# versus 37.8# for Google. Countrywide Financial, which
was badly hurt by the subprime mortgage debacle, had negative earnings and
thus a negative P/E. The Google and Countrywide data demonstrate that strong
companies with good growth prospects have high P/Es while weaker companies
with poor prospects have low ratios.^14
4-6b Market/Book Ratio
The ratio of a stock’s market price to its book value gives another indication of how
investors regard the company. Companies that are well regarded by investors—which
4-6 Market Value Ratios
Ratios that relate the firm’s
stock price to its earnings
and book value per share.Market Value Ratios
Ratios that relate the firm’s
stock price to its earnings
and book value per share.Price/Earnings (P/E)
Ratio
The ratio of the price per
share to earnings per
share; shows the dollar
amount investors will pay
for $1 of current earnings.Price/Earnings (P/E)
Ratio
The ratio of the price per
share to earnings per
share; shows the dollar
amount investors will pay
for $1 of current earnings.(^14) Security analysts also look at the Price-to-Free-Cash-Flow ratio. In addition, analysts consider the PEG, or P/E to
growth, ratio where the P/E is divided by the! rm’s forecasted growth rate. Allied’s growth rate as forecasted by a
number of security analysts for the next 5 years is 7.0%, so its PEG! 9.8/7.0! 1.4#. The lower the ratio, the
better; and most! rms have ratios in the range of 1.0# to 2.0#. We note, though, that P/E ratios jump around
from year to year because earnings and forecasted growth rates $ uctuate. Like other ratios, PEG ratios are
interesting, but must be interpreted with care and judgment.