The last component of the formula above, 1 – T, specifies how much of the firm's ROE is due to its tax rate. A lower tax rate will increase the value of this multiplier and hence increase ROE. While it is in the best interest of the firm to have the lowest tax expense possible, increases in ROE due solely to a lower tax rate are not sustainable and could indicate that management is trying to manipulate ROE. All else being equal, a firm that is able to generate a higher ROE due to increased profit margin and/or increased total assets turnover is preferable to one that relies on financial leverage and an abnormally low tax rate.
Market Ratios
If the firm has equity that is publicly traded, one can use market ratios to get an indication of how the market values the firm versus peers (cross-sectional) or relative to its own historical performance (time-series). Because the price of equity is determined by market supply and demand forces, management can be evaluated on how the market views their performance; market value ratios give management an idea of what the firm's investors think of the firm's performance and future prospects. The most common market ratio is the price to earnings (P/E) ratio, calculated as
Note: Old Pueblo Lithographers does not trade in the public market; therefore, no examples of market ratios are available to use as examples.
The ratio specifies how much the market is willing to pay for $1 of the company's earnings. Earnings are a chief driver of investment value, and a higher P/E ratio versus its peers indicates that the market is confident in the firm's ability to generate future earnings. The P/E ratio can be calculated based on the firm's last 12 months’ EPS (trailing P/E) or on the next 12 months’ expected EPS (forward P/E).
The P/E ratio has some drawbacks that derive from the characteristics of EPS. First, EPS can be negative, and the P/E ratio does not make economic sense in that case. Second, the EPS calculation may have large transient components that do not adequately reflect the ongoing operations of the firm. Finally, managers have flexibility in the application of accounting standards used in calculating earnings. In making such choices, managers may distort EPS as an accurate reflection of economic performance. All these factors may affect the comparability of P/Es among companies.
Certain types of privately held companies, including companies organized in partnership form, have long been valued by a multiple of annual sales. The price to sales (P/S) ratio is calculated as
where Sales per Share = Annual Sales/Shares outstanding.
The P/S market valuation alleviates some of the concerns that are present in the P/E ratio. For example, sales are generally less subject to distortion or manipulation than are EPS. Also, as long as the company has begun selling its products or services, the sales figure will always be positive even though EPS can be negative. This point, however, is also a drawback of the P/S ratio, as companies can have sales but consistently post negative earnings. A final reason is that sales are generally more stable than EPS, which reflects operating and financial leverage, and is therefore more meaningful for the firm's economic performance.
The price to book value ratio (P/BV) is also a popular measure of market value. The book value represents the investment that common shareholders have made in the company. The P/BV ratio is
where Book Value per Share (BVPS) = Shareholders’ Equity/Common stock shares outstanding.
Because the purpose of this ratio is to value common stock, any value attributable to preferred stock must be subtracted from shareholders’ equity. Like the P/S ratio, the P/BV can be used even if EPS are negative. Book value is also more stable and can be used if EPS are abnormally high or low.
Numerous other market valuation measures can be calculated, including price to cash flow (P/CF) and enterprise value to EBITDA (EV/EBITDA). The purpose here is not to list them all but rather give an overview and demonstrate how market ratios can be used to gauge how the market values the company. By comparing these ratios against peer companies or historical firm measures, management can get a sense of whether the market agrees on the firm's trajectory.
Limitations of Financial Ratios
There are some important limitations to using financial ratios. First, some firms operate in very unusual, different industries. For these companies, it is difficult to find a meaningful set of industry-average ratios when performing cross-sectional analysis. Second, macroeconomic events such as inflation or recessions can distort a company's financial statements during these disruptive periods. A time-series ratio analysis that covers a disruptive period of time must be interpreted carefully using both skill and judgment. Similarly, seasonal factors can distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer's inventory may be high in the summer in preparation for the back-to-school season. As a result, the company's days of inventory will be high and its ROA low in summer before the back-to-school sales period. In general, ratio analysis conducted in a mechanical, unthinking manner does not provide good, useful information. On the other hand, if used intelligently, ratio analysis can provide insightful information.
Summary
Using financial ratios is part art and part science. The technique is referred to as “quantitative” because the ratios themselves are calculated mathematically. However, the methodological technique actually provides both a quantitative measurement and a lens through which to view the organization. On one hand, the lens is a quantitative lens because it allows us to view trends and make comparisons using numeric calculations. On the other hand, it is a fundamental qualitative lens because the interpretation of the ratios provides information about the capabilities of management and the quality of the choices and decisions made.
Recall the discussion of “quality of earnings.” For any firm, the desired quantitative outcome is high ROE (when measured as a trend and when benchmarked against a peer group); however, it is always preferred that the firm's ROE be generated via a qualitatively superior process, and ratio analysis is helpful in identifying the quality of that process. By being proficient in using ratio analysis, the ROE of the firm can be quantified and the qualitative manner in which management has achieved the results understood. Virtually all ratios do not just tell us what the quantitative measurement is; rather, each measurement implies a management choice or capability (or failure) with respect to the choices that generated the numbers that are measured by the ratio.
The summary of a ratio analysis for Old Pueblo Lithographers is shown in Table 4.1.
Old Pueblo Lithographers has generated results as follows:
1 With respect to liquidity, the company has been able to improve its position in both ratios year over year, and it also is above the industry average for 2013. The firm seems to be in a good position for meeting its short-term obligations.
2 The leverage ratios indicate a mostly positive story. Old Pueblo Lithographers has been able to lower its debt to equity and debt to total assets ratios, indicating less financial leverage. It also has improved on its times interest earned and fixed coverage charge ratios in the past year. Compared to industry averages, the firm has a lower debt structure, but it is below average in both coverage ratios.
3 The profitability ratios, however, tell a different story and indicate an area that the firm must focus on improving. Gross profit margin, net profit margin, and ROE improved year over year, while operating margin