Question

please, in your own words answer the following question

- What conclusion can you draw if you were given the following two market ratios?

	SBUX	MCD
PE ratio	17.67	15.74
Market to Book Ratio	6.14	6.12

- and What are the disadvantages of using ratio analysis? (explain at least 5 disadvantages )

Answer 1

To answer this question we sholud understan about these two ratios given in the question.

P/E ratio and what it means: It is also known as price to earning ratio which is calculated by using formula : Current market price per share divided by Earnings per share.

• We use this metric to interpret market value of a company's share with its earnings, so that we can interpret whether stock is overvalued or undervalued or it can be at its fair price.
• From P/E ratio investors have some expectations, if a company's P/E ratio is high compared to its competitors the investors will look out for its growth in future.
• Now if we see the P/E ratio for Starbucks(SBUX) it is 17.67 and McDonald's it is 15.74 which is lower than the SBUX which means that the investors are ready to pay high for Starbucks than for McDonald's for its one dollar of earnings. But if we see the industry average both are having good P/E ratio.

Market to Book ratio: It is a financial metric used to evaluate a company's current market value compared to its book value. In short we can say this ratio is used to evaluate a company's net assets compared to its market price of stocks.

• Market to Book value ratio for Starbucks is 6.14 and for McDonalds it is 6.12 which is slightly less than the Starbucks. what we infer from here is that market price is 6.14 time more than its book value for Starbucks and similarly for the McDonalds.
• Ratio more than 1 is considered that the stock is overvalued and less than 1 is considered as the stock is undervalued.
• If the ratio is high means you are paying too much for what would be left if the company goes bankrupt.

Disadvantages of using ratio analysis:

(1). The information we using for ratio analysis is from the past data but future can be totally different from what we are seeing through past. Means use of historical data can give an idea of what happened in past but again in future it can be different.

(2). There are certain policies that companies are following when they disclose their financial information to the public, if a company has changed its policy the values that we are going to use for the comparison may also have changed.

(3). Operational changes may also lead to confusing and misleading results if company has done significant changes in supply chains or any other operational structure. So if we will compare the results before nad after changes it may be confusing.

(4). Seasinal effect can also have an impact on the results of the ratio analysis, so an analyst should have the knowledge of that.

(5). Manipulation of financial results is the another limitation of ratio analysis. Ratio analysis is done on the basis of financial reports disclosed by the company but it can be possible that to better represent the company's performance the management has manipulated the results.

So, the ratio analysis alone can't be a tool to report actual nature or performance of the business.