Trend Analysis, Common Size Analysis, and Percent Change Analysis 389
Describe three ratios that relate a firm’s stock price to its earnings, cash flow,
and book value per share, and write out their equations.
How do market value ratios reflect what investors think about a stock’s risk and
expected rate of return?
What does the price/earnings (P/E) ratio show? If one firm’s P/E ratio is
lower than that of another, what are some factors that might explain the
difference?
How is book value per share calculated? Explain why book values often deviate
from market values.
Trend Analysis, Common Size Analysis,
and Percent Change Analysis
It is important to analyze trends in ratios as well as their absolute levels, for trends give
clues as to whether a firm’s financial condition is likely to improve or to deteriorate. To
do a trend analysis,one simply plots a ratio over time, as shown in Figure 10-1. This
graph shows that MicroDrive’s rate of return on common equity has been declining
since 1999, even though the industry average has been relatively stable. All the other
ratios could be analyzed similarly.
Common size analysisand percent change analysisare two other techniques
that can be used to identify trends in financial statements. Common size analysis is
also useful in comparative analysis, and some sources of industry data, such as Robert
Morris Associates, are presented exclusively in common size form.
In a common size analysis, all income statement items are divided by sales, and all
balance sheet items are divided by total assets. Thus, a common size income statement
shows each item as a percentage of sales, and a common size balance sheet shows each
item as a percentage of total assets. The advantage of common size analysis is that it
facilitates comparisons of balance sheets and income statements over time and across
companies.
FIGURE 10-1 Rate of Return on Common Equity, 1998–2002
16
14
12
10
ROE
(%)
1998 1999 2000 2001 2002
Industry
MicroDrive
Analysis of Financial Statements 385
