P2A.6 Financial Ratios - Market

Question 1

Market Ratios

Answer 1

1. Measures the company’s market potential and attractiveness as an investment.
2. When a market ratio ends with “yield”, it means that the dominator will be the market price of stock.

Question 2

Types of Market Ratios

Answer 2

1. Book Value per Share
2. Market to Book Ratio
3. Basic EPS
4. Diluted EPS
5. Earnings Yield
6. Dividend Yield
7. Dividend Payout Ratio
8. Price Earnings Ratio
9. Price to EBITDA Ratio
10. Shareholder Return

Question 3

Book Value per Share

Answer 3

1. Represents that amount the shareholders will receive if the net assets of the company are liquidated at book value.

Question 4

Book Value per Share Limitations

Answer 4

1. The book value is merely the accounting value of the company’s net assets and doesn’t incorporate the market value of stock.
2. Book value per share can’t measure or predict growth potential of an entity.
3. Book value is based on historical cost and accounting assumptions used by a given company. Result of the application of GAAP.

Question 5

Book Value per Share Formula

Answer 5

= Total shareholders’ equity - preferred equity / Number of Common Shares Outstanding

Question 6

Market to Book Ratio

Answer 6

1. Measures the company’s current stock price relative to its book value.
2. Is an indication of the investor’s expectation on the performance of stock.

Question 7

Market to Book Ratio Formula

Answer 7

= Current stock price / Book Value per Share

If >1, expect profits in the future
If < 1, expect losses in the future

Question 8

Basic Earnings per Share

Answer 8

1. Actual version of the EPS without considering dilutive elements.

Basic EPS = Net income - preferred dividends / Weighted Average Common Shares Outstanding

Question 9

Diluted Earnings per Share

Answer 9

1. Should be version of the EPS by considering the dilutive elements.
2. 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.
3. Shares are only deemed dilutive if they can cause the basic EPS to decrease.

Question 10

Diluted Earnings per Share Formula

Answer 10

Diluted EPS = Net income - preferred dividends / Diluted Weighted Average Common Shares Outstanding

Question 11

Options and Warrants

Answer 11

1. Most dilutive because they only affect the denominator of the EPS.

Question 12

Dilution Effect of Convertible Bonds

Answer 12

1. Interest expense from bond debt is eliminated from net income calculation in numerator, shares added to denominator to increase dilutive effect.
2. Measures the dilutive effect on EPS of converting bonds into common shares of stock at beginning of year.

Question 13

Dilution Effect of Convertible Bonds Formula

Answer 13

= (Total Debt * Debt Rate) * (1 -Tax Rate) / Common Shares to be issued if bonds are converted

Question 14

Dilution Effect of Preferred Stock

Answer 14

1. Preferred dividends are removed from net income calculation in numerator, shares added to denominator to increase dilutive effect.
2. Measures the dilutive effect on EPS of converting preferred shares of stock into common share of stock at beginning of year.

Question 15

Dilution of Effect of Preferred Stock Formula

Answer 15

= Preferred Dividend Earning (Cumulative) or Declared Dividend (Non Cumulative) / Common Shares to be issued if Preferred Shares are converted

Question 16

Earnings Yield Ratio

Answer 16

1. Ratio of EPS to market price per common share.
2. Measures the return on net income per common share over on the market price per common share.
3. Ratio is the reversed formula of the price earnings ratio.

= EPS / Current Market Price per Common Share

Question 17

Convertible Bonds on EPS

Answer 17

1. % convertible bond interest expense
2. Multiplied by (1 - tax rate)
3. Subtotal
4. Divide by: number of shares to be issued if bonds are converted
5. 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

Question 18

Dividend Yield Ratio

Answer 18

1. Represents the payout in terms of dividends relative to its market price.

= Annual Dividend per Share / Current Market Price per Share

Question 19

Dividend Payout Ratio

Answer 19

1. Represents the percentage of earnings that was paid out as dividends.

= Common Dividend / Earnings Available to Common Shareholders

Question 20

Price Earnings Ratio

Answer 20

1. An indicator to the investors expectation on the growth potential of the stock.
2. Expresses the relationship between the market price of a stock and the EPS.
3. 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

Question 21

Shareholder Return Ratio

Answer 21

1. 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

Question 22

Price to EBITDA Ratio

Answer 22

1. 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

Question 23

Limitations of Financial Ratios Analysis

Answer 23

1. The financial ratio itself isn’t useful except when compared to a benchmark.
2. Ratio is a numerical measure. Too much emphasis on these metrics may result in ignoring qualitative measures of performance management.
3. Ratio analysis can be distorted by seasonal fluctuations, economic cycles and business cycles.
4. Different accounting principles and applications can lead to distortion of comparison between companies.
5. Comparability may be affected by great disparities in inter-industry ratios.