market ratios Relate a firm's market value, as measured by its current share price, to certain accounting values.
Market ratios relate the firm's market value, as measured by its current share price, to certain accounting values. These ratios give insight into how well investors in the marketplace feel the firm is doing in terms of risk and return. They tend to reflect, on a relative basis, the common stockholders' assessment of all aspects of the firm's past and expected future performance. Here we consider two popular market ratios, one that focuses on earnings and another that considers book value.
price/earnings (P/E) ratio Measures the amount that investors are willing to pay for each dollar of a firm's earnings; the higher the P/E ratio, the greater the investor confidence.
Price/Earnings (P/E) Ratio
The price/earnings (P/E) ratio is commonly used to assess the owners' appraisal of share value.16 The P/E ratio measures the amount that investors are willing to pay for each dollar of a firm's earnings. The level of this ratio indicates the degree of
16. Use of the price/earnings ratio to estimate the value of the firm is part of the discussion of "Other approaches to common stock valuation" in Chapter 7.
confidence that investors have in the firm's future performance. The higher the P/E ratio, the greater the investor confidence. The P/E ratio is calculated as follows:
Market price per share of common stock
Earnings per share
If Bartlett Company's common stock at the end of 2009 was selling at $32.25, using the EPS of $2.90, the P/E ratio at year-end 2009 is
This figure indicates that investors were paying $11.10 for each $1.00 of earnings. The P/E ratio is most informative when applied in cross-sectional analysis using an industry average P/E ratio or the P/E ratio of a benchmark firm.
market/book (WE) ratio Provides an assessment of how investors view the firm's performance. Firms expected to earn high returns relative to their risk typically sell at higher M/B multiples.
Market/Book (M/B) Ratio
The market/book (M/B) ratio provides an assessment of how investors view the firm's performance. It relates the market value of the firm's shares to their book— strict accounting—value. To calculate the firm's M/B ratio, we first need to find the book value per share of common stock:
Book value per share Common stock equity of common stock Number of shares of common stock outstanding
Substituting the appropriate values for Bartlett Company from its 2009 balance sheet, we get
Book value per share _ $1,754,000 _ of common stock 76,262
The formula for the market/book ratio is
Market price per share of common stock Book value per share of common stock
Substituting Bartlett Company's end of 2009 common stock price of $32.25 and its $23.00 book value per share of common stock (calculated above) into the M/B ratio formula, we get
This M/B ratio means that investors are currently paying $1.40 for each $1.00 of book value of Bartlett Company's stock.
The stocks of firms that are expected to perform well—improve profits, increase their market share, or launch successful products—typically sell at higher M/B ratios-than the stocks of firms with less attractive outlooks. Simply stated, firms expected to earn high returns relative to their risk typically sell at higher M/B multiples. Clearly, Bartlett's future prospects are being viewed favorably by investors, who are willing to pay more than its book value for the firm's shares. Like P/E ratios, M/B ratios are typically assessed cross-sectionally, to get a feel for the firm's return and risk compared to peer firms.
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