Review of Accounting Studies, 6, 109–154, 2001
2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
Ratio Analysis and Equity Valuation:
From Research to Practice
Columbia University, Graduate School of Business, 3022 Broadway, Uris Hall 604, New York, NY 10027
STEPHEN H. PENMAN
Columbia University, Graduate School of Business, 3022 Broadway, Uris Hall 612, New York, NY 10027
Abstract. Financial statement analysis has traditionally been seen as part of the fundamental analysis required
for equity valuation. But the analysis has typically been ad hoc. Drawing on recent research on accounting-based
valuation, this paper outlines a ﬁnancial statement analysis for use in equity valuation. Standard proﬁtability
analysis is incorporated, and extended, and is complemented with an analysis of growth. An analysis of operating
activities is distinguished from the analysis of ﬁnancing activities. The perspective is one of forecasting payoffs
to equities. So ﬁnancial statement analysis is presented as a matter of pro forma analysis of the future, with
forecasted ratios viewed as building blocks of forecasts of payoffs. The analysis of current ﬁnancial statements is
then seen as a matter of identifying current ratios as predictors of the future ratios that determine equity payoffs.
The ﬁnancial statement analysis is hierarchical, with ratios lower in the ordering identiﬁed as ﬁner information
about those higher up. To provide historical benchmarks for forecasting, typical values for ratios are documented
for the period 1963–1999, along with their cross-sectional variation and correlation. And, again with a view to
forecasting, the time series behaviorofmanyof the ratios is also described and their typical “long-run, steady-state”
levels are documented.
Keywords: Financial statement analysis, ratio analysis, equity valuation
It goes almost without saying that, in an applied discipline like accounting, the aim of
research is to affect practice. Theory can be admired on a number of dimensions, buta stream
of research is ultimately judged on the products it delivers, how it enhances technology.
Engineering and medical research, to name just two endeavors, have this orientation. Our
colleagues in ﬁnance have been successful in product development. While making major
contributions to economic theory, they have also engineered such products as derivative
pricing, risk measurement, hedging instruments, portfolio insurance, and asset allocation,
some, to be sure, more successful than others.
Inthearea of equity analysis,researchinﬁnance has notbeensuccessful.Equity analysis—
or fundamental analysis—was once the mainstream of ﬁnance. But, while enormous steps
have been taken in pricing derivatives on the equity, techniques to value equities have not
advanced much beyond applying the dividend discount model. So-called asset pricing mod-
els, like the Capital Asset Pricing Model, have been developed, but these are models of risk
and the expected return, not models that instruct how to value equities. Real option anal-
ysis has been applied to equity valuation, but the measurement problems are signiﬁcant.
Some progress has been made by accounting researchers in what has come to be referred
to as accounting-based valuation research. That is not surprising. Equity analysis is largely
an analysis of information, and accountants deal with information about ﬁrms. This paper
carries the recent research to the level of product design.