Friday, February 8, 2013

Earnings per Share, Price-Earnings Ratio, Dividend Yield, and Book Value per Share

Earnings per Share, Price-Earnings Ratio, Dividend Yield, and Book Value per ShareDecision Analysis

Earnings per Share

A1 Compute earnings per share and describe its use.

The income statement reports earnings per shareAmount of income earned by each share of a company’s outstanding common stock; also called net income per share., also called EPS or net income per share, which is the amount of income earned per each share of a company’s outstanding common stock. The basic earnings per shareNet income less any preferred dividends and then divided by weighted-average common shares outstanding. formula is shown in Exhibit 13.17. When a company has no preferred stock, then preferred dividends are zero. The weighted-average common shares outstanding is measured over the income reporting period; its computation is explained in advanced courses.

EXHIBIT 13.17Basic Earnings per Share

To illustrate, assume that Quantum Co. earns $40,000 net income in 2011 and declares dividends of $7,500 on its noncumulative preferred stock. (If preferred stock is noncumulative, the income available [numerator] is the current period net income less any preferred dividends declared in that same period. If preferred stock is cumulative, the income available [numerator] is the current period net income less the preferred dividends whether declared or not.) Quantum has 5,000 weighted-average common shares outstanding during 2011. Its basic EPS3 is


Price-Earnings Ratio

A2 Compute price-earnings ratio and describe its use in analysis.

Point: The average PE ratio of stocks in the 1950–2010 period is about 14.

A stock’s market value is determined by its expected future cash flows. A comparison of a company’s EPS and its market value per share reveals information about market expectations. This comparison is traditionally made using a price-earnings (or PE) ratio Ratio of a company’s current market value per share to its earnings per share; also called price-to-earnings., expressed also as price earnings, price to earnings, or PE. Some analysts interpret this ratio as what price the market is willing to pay for a company’s current earnings stream. Price-earnings ratios can differ across companies that have similar earnings because of either higher or lower expectations of future earnings. The price-earnings ratio is defined in Exhibit 13.18.

EXHIBIT 13.18Price-Earnings Ratio

This ratio is often computed using EPS from the most recent period (for Amazon, its PE is 52; for Altria, its PE is 13). However, many users compute this ratio using expected EPS for the next period.

Point: Average PE ratios for U.S. stocks increased over the past two decades. Some analysts interpret this as a signal the market is overpriced. But higher ratios can at least partly reflect accounting changes that have reduced reported earnings.

Some analysts view stocks with high PE ratios (higher than 20 to 25) as more likely to be overpriced and stocks with low PE ratios (less than 5 to 8) as more likely to be underpriced. These investors prefer to sell or avoid buying stocks with high PE ratios and to buy or hold stocks with low PE ratios. However, investment decision making is rarely so simple as to rely on a single ratio. For instance, a stock with a high PE ratio can prove to be a good investment if its earnings continue to increase beyond current expectations. Similarly, a stock with a low PE ratio can prove to be a poor investment if its earnings decline below expectations.

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