Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionII. Financial Statements
and Long−Term Financial
Planning- Working with Financial
Statements
© The McGraw−Hill^105
Companies, 2002Notice that book value per share is total equity (not just common stock) divided by the
number of shares outstanding.
Because book value per share is an accounting number, it reflects historical costs. In
a loose sense, the market-to-book ratio therefore compares the market value of the
firm’s investments to their cost. A value less than 1 could mean that the firm has not
been successful overall in creating value for its stockholders.
Market-to-book ratios in recent years appear high relative to past values. For exam-
ple, for the 30 blue-chip companies that make up the widely followed Dow-Jones In-
dustrial Average, the historical norm is about 1.7; however, the market-to-book ratio for
this group has recently been twice this size.
Conclusion
This completes our definitions of some common ratios. We could tell you about more of
them, but these are enough for now. We’ll leave it here and go on to discuss some ways
of using these ratios instead of just how to calculate them. Table 3.8 summarizes the
ratios we’ve discussed.
THE DU PONT IDENTITY
As we mentioned in discussing ROA and ROE, the difference between these two prof-
itability measures is a reflection of the use of debt financing, or financial leverage. We
illustrate the relationship between these measures in this section by investigating a fa-
mous way of decomposing ROE into its component parts.
To begin, let’s recall the definition of ROE:
Return on equity If we were so inclined, we could multiply this ratio by Assets/Assets without changing
anything:
Return on equity Notice that we have expressed the ROE as the product of two other ratios—ROA and
the equity multiplier:
ROE ROAEquity multiplier ROA(1 Debt-equity ratio)Assets
Total equityNet income
AssetsAssets
AssetsNet income
Total equityNet income
Total equityNet income
Total equityCONCEPT QUESTIONS
3.3a What are the five groups of ratios? Give two or three examples of each kind.
3.3bTurnover ratios all have one of two figures as the numerator. What are these two
figures? What do these ratios measure? How do you interpret the results?
3.3c Profitability ratios all have the same figure in the numerator. What is it? What do
these ratios measure? How do you interpret the results?
3.3dGiven the total debt ratio, what other two ratios can be computed? Explain how.CHAPTER 3 Working with Financial Statements 73