The Foundation
3.6 Market Value Ratios
66 THEFOUNDATION
Return on common equity
Adjusted profit margin
Total asset turnover
Common equity multiplier
= × × (3.28a)
Return on common equity
Net income Pfd dividends Sales
Sales Average total assets
Average total assets Average common equity
= − × ×
(3.28b) Because Home Depot does not have any preferred stock, the DuPont analysis for return on common equity is identical to the return on equity analysis.
Managers and analysts can obtain additional insight into a firm’s ROE by performing an extended DuPont analysis:
Return on equity=
Operating profit margin
Total asset turnover
Interest expense
rate
Financial leverage multiplier
Tax retention
rate
⎛
⎝
⎜⎜
⎞
⎠
⎟⎟
⎛
⎝
⎜⎜
⎞
⎠
⎟⎟ −⎛
⎝
⎜⎜
⎞
⎠
⎟⎟
⎡
⎣
⎢⎢
⎢
⎤
⎦
⎥⎥
⎥
⎛
⎝
⎜⎜
⎞
⎠
⎟⎟
⎛
⎝
⎜⎜
⎞
⎠
⎟⎟
(3.29a)
Return on equity=
EBIT Sales
Sales Assets
Interest expense Assets
Total assets
Equity )
⎛
⎝⎜
⎞
⎠⎟
⎛
⎝⎜
⎞
⎠⎟ − ⎛
⎝⎜
⎞
⎠⎟
⎡
⎣⎢
⎢
⎤
⎦⎥
⎥
⎛
⎝⎜
⎞
⎠⎟ −
( 1 t (3.29b)
We can now attribute changes in return on equity to changes in the levels of operating profits generated by sales, the sales generated from total assets, the firm’s interest expense relative to its total assets, the leverage factor employed in the financing of the firm’s assets, and the taxation of the firm’s profits.
Concept Check 3.5
1 What do profitability ratios tell us about a firm? What are the most commonly used profitability ratios?
2 Why will the net profit margin ratio, as defined in Equation 3.22, not provide a fair comparison between firms with similar operating profit margins but widely differ- ing long-term debt ratios? Can you suggest a modification to Equation 3.22 that would adjust for different levels of debt financing?
3 Why might the ROA and ROE for a firm not be an accurate measure of the firm’s profitability based on its investments in assets or equity, respectively?
4 How can traditional DuPont analysis or extended DuPont analysis provide addi- tional insight into changes in a firm’s profitability?
Price/earnings Ratio
The price/earnings (P/E) ratio, one of the most widely used financial ratios, is com- puted by dividing the market price per share of the firm’s common stock by its earnings per share.
Price/earnings ratio =
Market price per share
Earnings per share (3.30)
The P/E ratio indicates how much investors are willing to pay per dollar of earnings for shares of the firm’s common stock. It provides an important indication of how the market perceives the growth and profit opportunities of a firm. High growth firms with strong future profit opportunities will command higher P/E ratios than firms with lower expected growth and profits. The P/E ratio has several potential shortcomings. For example, a firm can have negative earnings, which produces a meaningless P/E ratio. In addition management can distort reported earnings because of the discretion allowed by accounting practices.
The P/E ratio for Home Depot is computed below.
Price/earnings ratio =
$35.15
$ .1 57 = 22.39 times
Since our ratio analysis has focused primarily on assessing Home Depot’s recent perform- ance, we average the stock price, at the end of fiscal year 2001 and 2002. We use an estimate of the average price during the fiscal year in which the earnings occurred. Investment analysts frequently compute P/E ratios by dividing an estimate of next year’s earnings by the current stock price (leading P/E ratio) or by dividing last year’s earnings by the current stock price (lagging P/E ratio).
Market-to-book Value Ratio
A firm’s market-to-book value ratio is computed by dividing the market value of the firm’s equity by its book value of equity.
Market-to-book value ratio =
Market value of equity
Book value of equity (3.31)
In this ratio, book value of equity equals total assets minus total liabilities less preferred stock. The market-to-book value ratio measures how much value the firm has created for its shareholders. To the extent the ratio exceeds 1.0 times, management has succeeded in creating value for the shareholders. If the book value of a firm’s equity is understated due to inflation, the ratio will provide an imprecise measure of this relationship. Home Depot’s market to book ratio is computed below:
Market-to-book value ratio = 2,336 million shares $20.90 per share
$19,802 million
× = 2.47 times
68 THEFOUNDATION
Table 3.6 Market value ratios for Home Depot and Lowe’s for FY 2002
Market value ratios Home Depot Lowe’s
Price/earnings 22.39x 21.13x
Market-to-book value 2.47x 3.22x
Dividend yield 1.00% 0.26%
Dividend payout 13.38% 4.76%
Dividend Yield and Payout
Dividend yield is computed by dividing a firm’s dividends per share by the market price of its common stock.
Dividend yield =
Dividends per share
Market price per share (3.32)
Dividend yield represents part of a stock’s total return; another part of a stock’s total return is price appreciation. The dividend payout is the percentage of a firm’s earnings paid out as cash dividends.
Dividend payout =
Cash dividends per share
Earnings per share (3.33)
The dividend yield and dividend payout ratios for Home Depot are shown below.
Dividend yield =
$0.21
$20 90. = 0.0100 = 1.00%
Dividend payout =
$0.21
$ .1 57 = 0.1338 = 13.38%
Since we used Home Depot’s stock price at the end of fiscal year 2002, this dividend yield was a current annual dividend yield on February 2, 2003.
Table 3.6 reports the market value ratios for Home Depot and Lowe’s. Until FY 2002, Home Depot had much higher P/E and market-to-book ratios than Lowe’s. Both ratios incorporate a firm’s stock price, and Home Depot’s stock price fell from $49.40 per share on February 3, 2002 to $20.90 per share on February 2, 2003. As a result, Home Depot’s P/E and market-to-book ratios fell substantially. By comparison, Lowe’s stock price fell from
$45.70 per share on its fiscal year-end date of February 1, 2002 to $34.18 on its fiscal year-end date of January 31, 2003, a much smaller relative decline over a similar period. Both firms have relatively low dividend yields and dividend payouts.
Concept Check 3.6
1 What do market value ratios tell about a firm? What are some commonly used market value ratios?
2 What does a high P/E ratio suggest about a firm’s future growth opportunities?
3 Many investment analysts define growth stocks as those of firms with high P/E and market-to-book value ratios. Would such firms typically have high or low dividend payouts? Would Home Depot and Lowe’s be considered growth stocks?
4 Many investment analysts define value stocks as those of firms with low P/E and market-to-book value ratios and high dividend payouts. Would such stocks be attractive investments?