Chapter 5:  Financial Statement Analysis: Price Ratios

In this chapter, we extend ratio analysis to price based ratios.   A major difference between business ratios and price ratios is that emphasis now shifts to forward looking analysis.  The market price of a stock reflects future performance (i.e., expected return) and discounts this expected return by assessing a company’s risk.  As a result, price ratios represent the market’s scorecard of how the company is performing along the set of dimensions covered in Chapter’s 3 and 4 taking into account forward looking information. 

Figure 1:  Price Ratios

The market’s scorecard includes assessing the quality of the accounting earnings and the credit risk of the firm.  There have been persistent questions raised in accounting research on whether the market correctly assesses earnings quality.  This research studies the use of and relative importance of accounting accruals to accounting net income measures.  Because accounting accruals must reverse over time these studies have implications for assessing both the expected return and the risk of a company.  The Valuation Tutor software performs a comprehensive analysis of earnings quality working directly with current accounting disclosures.  The credit rating models assess whether a company is a going concern or is a distressed firm and calculates the likelihood that a firm going to go bankrupt.

We start with price ratios.  Extreme price ratios usually provide a signal that forward looking information, beyond standard financial disclosures, is significant.  Recall from Chapter 2 that the MD&A section of the 10-K has been subjected to criticism.  A recent SEC study concluded that forward looking information disclosures can be improved.  As a result, studying price ratios is an important means of assessing whether the MD&A and related sources should be subjected to closer scrutiny.

Perhaps the most famous price-based ratio is the Price to Earnings (P/E) ratio, which is the price of the stock divided by the earnings per share.  This ratio measures the amount investors in the market (or simply the “market”) are willing to pay per dollar of earnings per share.  If you compare the P/E ratio of two firms, you could infer that investors who buy the stock feel that the stock with the high P/E ratio has stronger growth prospects.  A stock with a higher P/E ratio is said to be more expensive than one with a lower P/E ratio because you have to pay more per dollar of earnings for that stock.  Sometimes, the ratio is expressed in terms of a multiple; if a stock’s P/E ratio is 15, then we say that the stock is trading at a multiple of 15, or that the price is 15 times the annual earnings per share; a stock trading at 20 times earnings is then more “expensive” than one trading at 15 times earnings.  The usual reasons for such differences are expected earnings’ growth and/or risk.

Analyzing differences in earnings’ growth leads to another popular measure which is the PEG, or P/E to Growth, ratio.  That is, the P/E ratio is divided by the expected growth of earnings.  Generally, we expect that companies with a high P/E ratio will grow faster, and so simply comparing them on the basis of the P/E ratio would make us think that the high growth stocks are expensive.  The PEG ratio normalizes the P/E ratio by the growth rate, and therefore makes companies with different growth rates more comparable and which then lets an analyst explore issues such as earnings’ quality, degree of operating leverage and other sources of risk that can influence earnings.

In principle, you can construct a price based ratio using any of the firm’s activities, for example, the Price-Sales Ratio or the Price-Cash Flow ratio.   Each such ratio tells you how the market evaluates or “prices” or “values” that activity.  We can then make inferences about firms by ranking these measures.  This gives you a “market scorecard” of the activities of the firm, and tells you which activities are the drivers of the firm’s value. In other words, price ratios provide the markets evaluation of the firm’s business model and strategy.   

Given your understanding of the firm’s business strategy the market should value activities that are important to the strategy if implemented efficiently.  By adopting this line of reasoning you can see how price ratios become an important source of information to firms today that faces dynamic value chains as described in Chapter 4. 

The specific learning objective is:

·         To understand the major price based ratios, how to construct them from the firm’s financial statements, and how to interpret them

The chapter proceeds by introducing the most popular of all price based ratios, the Price to Earnings Ratio.  The following chart shows the P/E ratios for the stocks in the Dow Jones Industrial Average at the time of this writing. 

This “bottom line” ratio is extended to the Price Earnings to Growth (PEG) ratio.  This measures the market’s assessment of both financial and learning and growth perspectives of the firm.  We then proceed to the “top line” with the Price to Sales Revenue ratio which measures the market’s assessment of the customer perspective.  Next we introduce the Price to Book Value of Equity ratio, and show that by decomposing this ratio further, we obtain important measures of how the market prices the various internal activities of the firm. 

Finally, we introduce the Price to Cash Flow Ratio in aggregate and decomposed forms.  Compared to the Price Earnings Ratio, this provides insights into the quality of accounting earnings and the decomposed forms allow additional information to be extracted, such as how the market is pricing working capital management and capital investment decisions made by the firm.  If earnings management is an issue, then price to cash flow ratios may provide what on the surface appears to be an inconsistent picture.

After price ratios, we take you through a detailed analysis of earnings quality, and conclude the chapter with an analysis of credit ratings.

Before starting into the ratios, the next section provides the common set of steps required to recreate each of the formal Proctor and Gamble reconciliations directly from the 10-K filings for each ratio.  This follows the format introduced in Chapter 3 for the Business Ratios.