Question

Explain how at least one accounting method/standard difference between two companies could impact the following valuation indicators interpretation:

a. Price to Earnings Ratio

b. Price to Book Ratio

c. ROA

d. Price to Tangible Assets

e. Price to Sales

f. ROE Explain thoroughly

Answer 1

a) PE Ratio: PE Ratio will be affected if there is a change in method of valuation of the inventory of two companies. Suppose if company A opt for FIFO method and company B opt for LIFO method then this will affect PE ratio.

b) Price to Book Ratio: Price to book ratio will be affected if there is difference in method of depreciation or amortisation of intangible assets of two companies. As if two companies are exactly same but there is change in method of depreciation then it will affect the value of assets of comapny and same will affect the price to book value ratio.

c) ROA : ROA = Net operating income / Average total assets. ROA will be affected if there is change in presentation of provision. As if two companies are exactly same but there is change in presentation of provision like one comapany shows provision for bad debts and provision of depreciation as deducting from receivables and tangible assets then the comapny which show provision on the liability side results in higher average assets of the company and same will affect the ROE ratio.

d) Price to tangible assets: Price to tangible asset ratio will be affected if there is difference in method of depreciation of two companies. As if two companies are exactly same but there is change in method of depreciation then it will affect the value of tangible assets of comapny and same will affect the price to tangible asset ratio.

e) Price to sales ratio: Price to sales ratio will be affected if there is difference in method of recognition of revenue or change in recording of sales return of two companies. As if two companies are exactly same but there is change in method of recording of sales return like one company deduct sales return from the sales and other ccompany shows it on the debit side then it will affect the sales amount of comapny and same will affect the price to sales ratio.

f) ROE:ROE ratio = Net Income / Number of shares; ROE will be affected if there is difference in method of valuation of inventory or method of depreciation of two companies. As if two companies are exactly same but there is change in method of valuation of inventory or method of depreciation like one comapany value inventory on LIFO and other company measure it at FIFO basis then it will affect the Net Income of comapny and same will affect the ROE ratio.