More on ratio analysis

Analysts and investors often use return on equity (ROE) to compare profitability of a company with other firms in the industry. ROE is considered a very important measure, and managers strive to make the company’s ROE numbers look good.

If a firm takes steps that increase its expected future ROE, its stock price will (never or always or not necessarily)...................... increase.

Based on your understanding of the uses and limitations of ROE, which of the following projects should be chosen if they have the same risk and cost of capital?

(a)Project Y, with 40% ROE and a small investment, generating low expected cash flows

(b)Project X, with 35% ROE and a large investment, generating high expected cash flows

Suppose you are trying to decide whether to invest in a company that generates a high expected ROE, and you want to conduct further analysis on the company’s performance. If you wanted to conduct a trend analysis, you would:

(a)Analyze the firm’s financial ratios over time

(b)Compare the firm’s financial ratios with other firms in the industry for a particular year

You decide also to conduct a qualitative analysis based on the factors summarized by the American Association of Individual Investors (AAII). According to your understanding, a company with one key product is considered to be (more or less)..................... risky than companies with a wide range of products.