100 Part 2 Fundamental Concepts in Financial Management
4-7 TREND ANALYSIS
It is important to analyze trends in ratios as well as their absolute levels, for trends
give clues as to whether a! rm’s! nancial condition is likely to improve or to
deteriorate. To do a trend analysis, simply plot a ratio over time, as shown in
Figure 4-1. This graph shows that Allied’s ROE has been declining since 2005 even
though the industry average has been relatively stable. All of the other ratios could
be analyzed similarly, and such an analysis can be quite useful in gaining insights
as to why the ROE behaved as it did.4-7 Trend Analysis
An analysis of a firm’s
financial ratios over time;
used to estimate the
likelihood of improvement
or deterioration in its
financial condition.Trend Analysis
An analysis of a firm’s
financial ratios over time;
used to estimate the
likelihood of improvement
or deterioration in its
financial condition.SEL
F^ TEST Describe two ratios that relate a! rm’s stock price to its earnings and book
value per share and write their equations.
In what sense do these market value ratios re# ect investors’ opinions about a
stock’s risk and expected future growth?
What does the price/earnings (P/E) ratio show? If one! rm’s P/E ratio is lower
than that of another! rm, what factors might explain the di" erence?
How is book value per share calculated? Explain how in# ation and R&D pro-
grams might cause book values to deviate from market values.means low risk and high growth—have high M/B ratios. For Allied, we! rst! nd its
book value per share:Book value per share!
Common equity
_________________
Shares outstanding
! $940_____ 50! $18.80We then divide the market price per share by the book value per share to get the
market/book (M/B) ratio, which for Allied is 1.2#:Market/book (M/B) ratio! Mark____________________et pric e per shar e
Book value per share
! $23.06______
$18.80
! 1.2"Industry average! 1.7"Investors are willing to pay less for a dollar of Allied’s book value than for one of
an average food processing company. This is consistent with our other! ndings.
M/B ratios typically exceed 1.0, which means that investors are willing to
pay more for stocks than the accounting book values of the stocks. This situation
occurs primarily because asset values, as reported by accountants on corporate
balance sheets, do not re" ect either in" ation or goodwill. Assets purchased years
ago at pre-in" ation prices are carried at their original costs even though in" ation
might have caused their actual values to rise substantially; and successful com-
panies’ values rise above their historical costs, whereas unsuccessful ones have
low M/B ratios.^15 This point is demonstrated by Google and Countrywide: In the
winter of 2008, Google’s M/B ratio was 6.9#, while Countrywide’s was only
0.26#. Google’s stockholders now have $6.90 in market value per $1.00 of equity,
whereas Countrywide’s stockholders have only $0.26 for each dollar they
invested.Market/Book (M/B)
ratio
The ratio of a stock’s
market price to its book
value.Market/Book (M/B)
ratio
The ratio of a stock’s
market price to its book
value.(^15) The second point is known as “survivor bias.” Successful companies survive and are re$ ected in the averages,
whereas unsuccessful companies vanish and their low numbers are not re$ ected in the averages.