[MUSIC] In the last few videos we have seen various types of financial ratios using information from the balance sheet and income statement. In this video, we will relate a company's return on equity to measures of profitability, activity, and solvency ratios. This will help us identify what the company's doing correctly, and what it needs to improve. We will also talk about one stock market price based financial ratio. The Dupont identity gets its name from Dupont Corporation, which began using this idea from the early 1920s. It relates a company's return on equity to various financial ratios. It is easy to see what these financial ratios are. You start off with return on equity, which is defined as net income divided by average shareholder's equity. Let's multiply and divide by both revenue and average total assets. Net income divided by revenue is net profit margin, which is a profitability ratio. Revenue divided by average total assets is total asset turnover, which is an activity ratio. Average total assets divided by average shareholders' equity is called equity multiplier, and is a measure of the company's solvency. High values of the equity multiplier tell us that the company has high levels of debt, and low levels of equity. We now have ROE = Net profit margin x Total asset turnover x Equity Multiplier. This helps us attribute a company's low or high ROE to various factors measured by these three financial ratios. Let's take a look at Amazon's ROE for 2015. Early we calculated it to be 4.94% in 2015, its net profit margin was 0.56%, and its total asset turnover was 1.78. Amazon's average shareholder's equity, and average total assets we're $12.06 billion, and $59.97 billion, respectively. Dividing $59.97 billion by $12.06 billion, gives us Amazon's equity multiplier to be 4.97. You can verify that multiplying the net profit margin of 0.56%, the total asset turnover of 1.78, and the equity multiplier of 4.97, gives us the ROE of 4.94%. Amazon's ROE has improved over the last four years, why is this? During this time, its net profit margin has increased, which tells us that Amazon is doing a better job of controlling its expenses, leading to higher profits. However, the efficiency has decreased as its total asset turnover has decreased over the last few years. Another reason for its higher ROE is that its equity multiplier has increased, which means it borrowed more capital than raising equity capital. Increasing borrowing is not necessarily good, as it increases the chance of a company not paying off the loans on time. The last part of financial statement analysis in this course, is measuring a company's value from its financial statements, relative to its current stock price. There are a number of such ratios, but we are going to talk only about the price to earnings, P/E ratio here. One way to calculate P/E ratio is to use the EPS from the most recent income statement. The P/E ratio is defined as the market price for the company's shares on the date of the income statement, divided by the EPS. The P/E ratio tells us how much investors are willing to pay for each dollar of profits the company makes. One way of interpreting the P/E ratio is that it tells us what the future growth potential for the company is. The higher the P/E ratio, larger is its future potential. However, really high issues compared to its competitors or the rest of the market, is indicative of the stock being overpriced. Let's calculate the P/E ratio for Amazon, for this we need Amazon's stock price as of December 2015. We get these prices from Yahoo Finance. As of December 31, 2015, Amazon's stock price was $675.89. We can calculate the P/E ratio using both basic, as well as diluted EPS. For simplicity, we will use the basic EPS of $1.28. Dividing the share prices of $675.89 by the EPS of $1.28, gives an EPS of 528.04. For each $1 in profits earned, investors are willing to pay $528.04. This could mean that investors place a very high value on Amazon's future growth potential. Alternatively, Amazon's stock price is far higher than what its fundamentals justify, and should be sold. In the two of the past four years, Amazon has had negative P/E ratios. It is impossible to interpret a negative P/E ratio, as it does not make any sense as to why investors would be willing to pay anything for a company that is making losses. This brings us to the end of the financial statements and analysis part of this course. Next time, we will start looking at one of the key building blocks of finance, namely time value of money. [MUSIC]
