P2A.6 Financial Ratios - Market Flashcards
Market Ratios
- Measures the company’s market potential and attractiveness as an investment.
- When a market ratio ends with “yield”, it means that the dominator will be the market price of stock.
Types of Market Ratios
- Book Value per Share
- Market to Book Ratio
- Basic EPS
- Diluted EPS
- Earnings Yield
- Dividend Yield
- Dividend Payout Ratio
- Price Earnings Ratio
- Price to EBITDA Ratio
- Shareholder Return
Book Value per Share
- Represents that amount the shareholders will receive if the net assets of the company are liquidated at book value.
Book Value per Share Limitations
- The book value is merely the accounting value of the company’s net assets and doesn’t incorporate the market value of stock.
- Book value per share can’t measure or predict growth potential of an entity.
- Book value is based on historical cost and accounting assumptions used by a given company. Result of the application of GAAP.
Book Value per Share Formula
= Total shareholders’ equity - preferred equity / Number of Common Shares Outstanding
Market to Book Ratio
- Measures the company’s current stock price relative to its book value.
- Is an indication of the investor’s expectation on the performance of stock.
Market to Book Ratio Formula
= Current stock price / Book Value per Share
If >1, expect profits in the future
If < 1, expect losses in the future
Basic Earnings per Share
- Actual version of the EPS without considering dilutive elements.
Basic EPS = Net income - preferred dividends / Weighted Average Common Shares Outstanding
Diluted Earnings per Share
- Should be version of the EPS by considering the dilutive elements.
- Measures the EPS assuming all potential issuance such as convertible debt securities, convertible preferred shares, options and warrants are issued at the beginning of the year or on a specific date during the year.
- Shares are only deemed dilutive if they can cause the basic EPS to decrease.
Diluted Earnings per Share Formula
Diluted EPS = Net income - preferred dividends / Diluted Weighted Average Common Shares Outstanding
Options and Warrants
- Most dilutive because they only affect the denominator of the EPS.
Dilution Effect of Convertible Bonds
- Interest expense from bond debt is eliminated from net income calculation in numerator, shares added to denominator to increase dilutive effect.
- Measures the dilutive effect on EPS of converting bonds into common shares of stock at beginning of year.
Dilution Effect of Convertible Bonds Formula
= (Total Debt * Debt Rate) * (1 -Tax Rate) / Common Shares to be issued if bonds are converted
Dilution Effect of Preferred Stock
- Preferred dividends are removed from net income calculation in numerator, shares added to denominator to increase dilutive effect.
- Measures the dilutive effect on EPS of converting preferred shares of stock into common share of stock at beginning of year.
Dilution of Effect of Preferred Stock Formula
= Preferred Dividend Earning (Cumulative) or Declared Dividend (Non Cumulative) / Common Shares to be issued if Preferred Shares are converted
Earnings Yield Ratio
- Ratio of EPS to market price per common share.
- Measures the return on net income per common share over on the market price per common share.
- Ratio is the reversed formula of the price earnings ratio.
= EPS / Current Market Price per Common Share
Convertible Bonds on EPS
- % convertible bond interest expense
- Multiplied by (1 - tax rate)
- Subtotal
- Divide by: number of shares to be issued if bonds are converted
- Impact of convertible bonds on EPS: Subtotal / # of shares to be issued if bonds are converted
Ex: 2,500,000 * 5% = 125,000 (1-.30) = .70 = 87,500 (2,500,000/1,000 face amount) * 4 shares = 10,000 87,500/10,000 = 8.75
Dividend Yield Ratio
- Represents the payout in terms of dividends relative to its market price.
= Annual Dividend per Share / Current Market Price per Share
Dividend Payout Ratio
- Represents the percentage of earnings that was paid out as dividends.
= Common Dividend / Earnings Available to Common Shareholders
Price Earnings Ratio
- An indicator to the investors expectation on the growth potential of the stock.
- Expresses the relationship between the market price of a stock and the EPS.
- Ratio is the reversed formula for earnings yield.
= Current Market Price per Share / EPS
If ratio is high, expect growth
If ratio is low, expect a decline
Shareholder Return Ratio
- The return to shareholders from capital appreciation (change in stock price) and dividends received.
= Ending Stock Price - Beginning Stock Price + Annual Dividend per Share / Beginning Stock Price
Price to EBITDA Ratio
- Ratio of market price per share to EBITDA per share.
= Current Market Price per Share / EBITDA per share
If ratio is high, expect growth
If ratio is low, expect a decline
Limitations of Financial Ratios Analysis
- The financial ratio itself isn’t useful except when compared to a benchmark.
- Ratio is a numerical measure. Too much emphasis on these metrics may result in ignoring qualitative measures of performance management.
- Ratio analysis can be distorted by seasonal fluctuations, economic cycles and business cycles.
- Different accounting principles and applications can lead to distortion of comparison between companies.
- Comparability may be affected by great disparities in inter-industry ratios.
