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Lecture 5
Ratio Analysis (II)

Financial Leverage Effects
ROE = ROIC + [(ROIC – Cost of debt)×L-T Debt/Equity]
v L everaged firms accrue excess returns to their
shareholders so long as the rate of return on investments
financed by debt is greater than the cost of debt
...


Leverage Ratios
v How much debt does the firm have? That’s the
question answered by the leverage ratios
v Especially be on the lookout for companies with a
high proportion of fixed costs (high operating
leverage) and with lots of debt
...
”
v These ratios tell us what the firm is earning each
year relative to the burden the debt imposes
...


•  Price/Cash Flow

Analyzing the market value ratios
•  P/E: How much investors are willing to pay
for $1 of earnings
...

•  M/B: How much investors are willing to
pay for $1 of book value equity
...

•  P/E and M/B are high if ROE is high and
risk is low
...


P/E
P/CF
M/B

2007
12
...
21x
1
...
4x
-5
...
5x

2005
9
...
0x
1
...
2x
11
...
4x

Payout policy ratios
v Shows the percentage of a stock’s market
value returned as dividends to stockholders
each period
...
In the special case of the two-stage dividend discount
model, this relationship can be made explicit fairly simply:
P0 =

⎛ (1+ g)n ⎞
EPS0 * Payout Ratio *(1+ g)* ⎜1 −
⎝ (1+ r) n ⎠
r-g

EPS0 * Payout Ratio n *(1+ g)n *(1+ g n )
+
(r -g n )(1+ r)n

For a firm that does not pay what it can afford to in dividends,
substitute FCFE/Earnings for the payout ratio
...
0713 ron

⎛
(1
...
5 * (1,15) * ⎜1 −
3 ⎟
⎜
(1
...
5 * (1,15)3 * (1
...
52
(0
...
15)
(0
...
05) (1
...

v Financial analysis may indicate that
something is wrong, but it may not identify
the specific problem or show how to
correct it
...

v “Average” performance is not necessarily
good, perhaps the firm should aim higher
...

v “Window dressing” techniques can make
statements and ratios look better
...

•  When a leveraged firm accrues excess
returns to their shareholders?
•  Give examples of industry that are using
low margin/high turnover and high margin/
low turnover
...
Debt-equity ratio: a shipping company or a computer
software company
•  b
...
or Computer Graphics
Inc
...
Ratio of sales to assets: an integrated pulp and paper
manufacturer or a paper mill
•  d
...
Price-earnings multiple: Basic Sludge Company or
Fledgling Electronics

Quick Quiz (III)
•  Financial ratio analysis is conducted by four
groups of analysts: managers, equity investors,
long-term creditors and short-term creditors
...
D
...
has
realized an increase in its current ratio and a
drop in its total assets turnover ratio
...
What
explains these changes?

Quick Quiz (IV)
•  If the mean P/E ratio for an industry sector is 12,
and the company you are analyzing has a P/E of
18, what does this mean about investor’s view of
growth prospects?

Modify sectors’ P/E to be correct!
Sector

Sector average P/Es

Electricity

23

Leisure and hotels

21

Building materials

14

Food retailing

9



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