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Analyzing financial statements : security Analysis

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  1. Compute the sustainable growth rate for each firm, g = r x ROE, where r is the firm's retention rate. Since there may be substantial variation in the data from year to year you may wish to find the average retention rate and ROE over the past five years
  2. Compare the growth rates computed above with the P/E ratios of the firms. (It would be useful to plot P/E against g in a scatter diagram. This is easy to do in Excel.) Is there a relationship between g and P/E?
  3. What is the average PEG ratio (this is the ratio of the P/E ratio to the growth rate, ((P/E)/G)) for the firms in your sample? How much variation is there across firms in this industry?
  4. Find the price to book, price to sales, and price to cash flow ratios for each firm
  5. Based on the 5-year historical growth rate of earnings per share for each firm, how is the actual rate of the firm's earnings growth correlated with its sustainable growth rate that you computed in the beginning part of the exercise (calculate the correlation statistic using the built-in statistical function in Excel)?
  6. What factors might affect the future growth rate of earnings? Can you substantiate any major differences across these firms by examining the financial statements of the firms? Which of these factors might be foreseen by investors? Which would be unpredictable?

First, let's define what the 'price to book', 'price to sales' and 'price to cash flow' are. The price to book ratio (P/B Ratio) is a financial ratio usually used to compare the stock's market value to its book value. Book value is the term used to designate the portion of the company held by shareholders. Book value is calculated with the company's total assets over its total liabilities. The Price to book ratio is calculated by dividing the current closing price of the stock by the latest quarter's book value per share. It's also known as the 'Price equity ratio'. There are two ways to calculate the P/B Ratio. The first one is to divide the market capitalization by the company's total book value. The second one is to divide the company's current share price by the book value per share. Basically, to be clear, a low P/B ratio means that the stock is undervalued. But a low P/B ratio can also mean that something is wrong in the company. The P/B ratio also gives some idea of whether you are paying too much for what would be left in the company if gets bankrupted, in other words, if the investor is paying too much for what would be left in the company if it went bankrupt.

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