Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

II. Financial Statements

and Long−Term Financial

Planning

3. Working with Financial
   Statements

© The McGraw−Hill^103

Companies, 2002

For every dollar in equity, therefore, Prufrock generated 14 cents in profit, but, again,
this is only correct in accounting terms.
Because ROA and ROE are such commonly cited numbers, we stress that it is im-
portant to remember they are accounting rates of return. For this reason, these measures
should properly be called return on book assets and return on book equity. In fact, ROE
is sometimes called return on net worth.Whatever it’s called, it would be inappropriate
to compare the result to, for example, an interest rate observed in the financial markets.
We will have more to say about accounting rates of return in later chapters.
The fact that ROE exceeds ROA reflects Prufrock’s use of financial leverage. We will
examine the relationship between these two measures in more detail next.

Market Value Measures

Our final group of measures is based, in part, on information not necessarily contained
in financial statements—the market price per share of the stock. Obviously, these mea-
sures can only be calculated directly for publicly traded companies.
We assume that Prufrock has 33 million shares outstanding and the stock sold for $88
per share at the end of the year. If we recall that Prufrock’s net income was $363 mil-
lion, then we can calculate that its earnings per share were:

EPS $11

Price-Earnings Ratio The first of our market value measures, the price-earnings (PE)
ratio (or multiple), is defined as:

PE ratio 

 8 times

[3.22]

In the vernacular, we would say that Prufrock shares sell for eight times earnings, or we
might say that Prufrock shares have or “carry” a PE multiple of 8.

$88

$11

Price per share

Earnings per share

$363

33

Net income

Shares outstanding

CHAPTER 3 Working with Financial Statements 71

ROE and ROA

Because ROE and ROA are usually intended to measure performance over a prior period, it

makes a certain amount of sense to base them on average equity and average assets, re-

spectively. For Prufrock, how would you calculate these?

We first need to calculate average assets and average equity:

Average assets ($3,373 3,588)/2 $3,481

Average equity ($2,299 2,591)/2 $2,445

With these averages, we can recalculate ROA and ROE as follows:

ROA 10.43%

ROE 14.85%

These are slightly higher than our previous calculations because assets grew during the

year, with the result that the average is below the ending value.

$363

$2,445

$363

$3,481

EXAMPLE 3.4