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Â In the last few videos we have seen various types of financial ratios using

Â information from the balance sheet and income statement.

Â In this video, we will relate a company's return on equity

Â to measures of profitability, activity, and solvency ratios.

Â This will help us identify what the company's doing correctly, and

Â what it needs to improve.

Â We will also talk about one stock market price based financial ratio.

Â The Dupont identity gets its name from Dupont Corporation,

Â which began using this idea from the early 1920s.

Â It relates a company's return on equity to various financial ratios.

Â It is easy to see what these financial ratios are.

Â You start off with return on equity,

Â which is defined as net income divided by average shareholder's equity.

Â Let's multiply and divide by both revenue and average total assets.

Â Net income divided by revenue is net profit margin,

Â which is a profitability ratio.

Â Revenue divided by average total assets is total asset turnover,

Â which is an activity ratio.

Â Average total assets divided by average shareholders' equity is called

Â equity multiplier, and is a measure of the company's solvency.

Â High values of the equity multiplier tell us that the company has high levels of

Â debt, and low levels of equity.

Â We now have ROE = Net profit margin x Total asset turnover x Equity Multiplier.

Â This helps us attribute a company's low or

Â high ROE to various factors measured by these three financial ratios.

Â Let's take a look at Amazon's ROE for 2015.

Â Early we calculated it to be 4.94% in 2015,

Â its net profit margin was 0.56%, and its total asset turnover was 1.78.

Â Amazon's average shareholder's equity, and

Â average total assets we're $12.06 billion, and $59.97 billion, respectively.

Â Dividing $59.97 billion by $12.06 billion,

Â gives us Amazon's equity multiplier to be 4.97.

Â You can verify that multiplying the net profit margin of 0.56%,

Â the total asset turnover of 1.78, and

Â the equity multiplier of 4.97, gives us the ROE of 4.94%.

Â Amazon's ROE has improved over the last four years, why is this?

Â During this time, its net profit margin has increased, which tells us that Amazon

Â is doing a better job of controlling its expenses, leading to higher profits.

Â However, the efficiency has decreased as its total asset turnover

Â has decreased over the last few years.

Â Another reason for its higher ROE is that its equity multiplier has increased,

Â which means it borrowed more capital than raising equity capital.

Â Increasing borrowing is not necessarily good,

Â as it increases the chance of a company not paying off the loans on time.

Â The last part of financial statement analysis in this course,

Â is measuring a company's value from its financial statements,

Â relative to its current stock price.

Â There are a number of such ratios, but

Â we are going to talk only about the price to earnings, P/E ratio here.

Â One way to calculate P/E ratio is to use

Â the EPS from the most recent income statement.

Â The P/E ratio is defined as the market price for

Â the company's shares on the date of the income statement, divided by the EPS.

Â The P/E ratio tells us how much investors are willing to pay for

Â each dollar of profits the company makes.

Â One way of interpreting the P/E ratio

Â is that it tells us what the future growth potential for the company is.

Â The higher the P/E ratio, larger is its future potential.

Â However, really high issues compared to its competitors or

Â the rest of the market, is indicative of the stock being overpriced.

Â Let's calculate the P/E ratio for Amazon, for

Â this we need Amazon's stock price as of December 2015.

Â We get these prices from Yahoo Finance.

Â As of December 31, 2015, Amazon's stock price was $675.89.

Â We can calculate the P/E ratio using both basic, as well as diluted EPS.

Â For simplicity, we will use the basic EPS of $1.28.

Â Dividing the share prices of $675.89 by the EPS

Â of $1.28, gives an EPS of 528.04.

Â For each $1 in profits earned, investors are willing to pay $528.04.

Â This could mean that investors place a very high value on Amazon's future

Â growth potential.

Â Alternatively, Amazon's stock price is far higher than what its fundamentals justify,

Â and should be sold.

Â In the two of the past four years, Amazon has had negative P/E ratios.

Â It is impossible to interpret a negative P/E ratio, as it does not make

Â any sense as to why investors would be willing to pay anything for

Â a company that is making losses.

Â This brings us to the end of the financial statements and

Â analysis part of this course.

Â Next time, we will start looking at one of the key building blocks of finance,

Â namely time value of money.

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