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Principles of Finance

6.5 Market Value Ratios

Principles of Finance6.5 Market Value Ratios

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

By the end of this section, you will be able to:

  • Calculate earnings per share to determine the portion of profit allocated to each outstanding share of common stock.
  • Evaluate firm value using the price/earnings ratio and book value per share.

In this section we will turn our attention to market value ratios, measures used to assess a firm’s overall market price. Common ratios used include earnings per share, the price/earnings ratio, and book value per share.

Earnings per Share (EPS)

Earnings per share (EPS) measures the portion of a corporation’s profit allocated to each outstanding share of common stock. An increasing earnings per share can drive up a stock price. Conversely, falling earnings per share can lower a stock’s market price. Earnings per share is also a component in calculating the price-to-earnings ratio (the market price of the stock divided by its earnings per share), which many investors find to be a key indicator of the value of a company’s stock.

It’s key to note, however, that EPS, like any ratio, should be used with caution and in tandem with other ratios and contextual data. Many financial professionals choose not to rely on income statement data and, similarly, EPS because they feel the cash flow statement provides more reliable and insightful information.

Concepts In Practice

Alibaba Group Earnings Announcements Continue to Exceed Market Expectations

Alibaba, a Chinese-based company traded in the United States, exceeded market expectations in 2020 quarterly earnings releases. In the November 2020 earnings release, Alibaba reported earnings per share of 17.97 yuan versus market estimates of 14.33. Despite many companies struggling due to the pandemic, Alibaba reported strong earnings as a result of the surge in online shopping and remote work.

(sources: "Alibaba Beats Estimates as Pandemic Fuels Online, Cloud Computing Demand.” CNBC. August 20, 2020. https://www.cnbc.com/2020/08/20/alibaba-beats-quarterly-revenue-estimates.html; Emily Bary. “Alibaba Earnings Top Expectations as Pandemic Drives Increased Digital Purchases. Market Watch. August 20, 2020. https://www.marketwatch.com/story/alibaba-earnings-top-expectations-as-pandemic-drives-increased-digital-purchases-2020-08-20; Matthew Johnston. “Alibaba Earnings: What Happened.” Investopedia. November 5, 2020. https://www.investopedia.com/alibaba-q2-2021-earnings-5085444; Chris Versace. “Why S&P 500 EPS Expectations Showcase the Need for Thematic Investing.” Tematica Research. June 3, 2020. https://www.tematicaresearch.com/why-sp-500-eps-expectations-showcase-the-need-for-thematic-investing)

Calculating Earnings per Share

Earnings per share is the profit a company earns for each of its outstanding common shares. Both the balance sheet and income statement are needed to calculate earnings per share. The balance sheet provides details on the preferred dividend rate, the total par value of the preferred stock, and the number of common shares outstanding. The income statement indicates the net income for the period. The formula to calculate basic earnings per share is

Earnings per Share=Net Income - Preferred DividendsWeighted Average Common Shares OutstandingEarnings per Share=Net Income - Preferred DividendsWeighted Average Common Shares Outstanding

By removing the preferred dividends from net income, the numerator represents the profit available to common shareholders. Because preferred dividends represent the amount of net income to be distributed to preferred shareholders, this portion of the income is obviously not available for common shareholders. While a number of variations of measuring a company’s profit, such as NOPAT (net operating profit after taxes) and EBITDA (earnings before interest, taxes, depreciation, and amortization), are used in the financial world, GAAP requires companies to calculate earnings per share based on a corporation’s net income, as this amount appears directly on a company’s income statement, which for public companies must be audited.

In the denominator, only common shares are used to determine earnings per share because earnings per share is a measure of earnings for each common share of stock. The denominator can fluctuate throughout the year as a company issues and buys back shares of its own stock. The weighted average number of shares is used on the denominator because of this fluctuation. To illustrate, assume that a corporation began the year with 600 shares of common stock outstanding and then on April 1 issued 1,000 more shares. During the period January 1 to March 31, the company had the original 600 shares outstanding. Once the new shares were issued, the company had the original 600 plus the new 1,000 shares, for a total of 1,600 shares for each of the next nine months—from April 1 to December 31. To determine the weighted average shares, apply these fractional weights to both of the stock amounts (see Figure 6.6).

Tabular representation of weighted shares. The table shows the number of shares, the portion of the year, and the end weighted shares. The formula is weighted shares equals number of shares times the portion of the year. For the period of January 1 through March 31, the equation is 600 times three twelfths, for a weighted share value of 150.  For the period of April 1 through December 31, the equation is 1600 times nine twelfths, for a weighted share value of 1200. Adding the these two values together, the weighted average shares equals 1350.
Figure 6.6 Weighted Shares

If the shares were not weighted, the calculation would not consider the time period during which the shares were outstanding.

To illustrate how earnings per share is calculated, assume Clear Lake Sporting Goods earns $35,000 in net income during the current year. During the year, the company also declared a $5,000 dividend on preferred stock and a $6,000 dividend on common stock. The company had 8,000 common shares outstanding the entire year. Clear Lake Sporting Goods has generated $3.75 of earnings ($35,000 less the $5,000 of preferred dividends) for each of the 8,000 common shares of stock it has outstanding.

Earnings per Share=$35,000-$5,0008,000=$3.75Earnings per Share=$35,000-$5,0008,000=$3.75

Measuring Performance with Earnings per Share

Earnings per share is a key profitability measure that both current and potential common stockholders monitor. Its importance is accentuated by the fact that GAAP requires public companies to report earnings per share on the face of a company’s income statement. This is the only ratio that requires such prominent reporting. If fact, public companies are required to report two different earnings per share amounts on their income statements—basic and diluted. We’ve illustrated the calculation of basic earnings per share. Diluted earnings per share, which is not demonstrated here, involves the consideration of all securities, such as stocks and bonds, that could potentially dilute, or reduce, the basic earnings per share.

Common stock shares are normally purchased by investors to generate income through dividends or to sell at a profit in the future. Investors realize that inadequate earnings per share can result in poor or inconsistent dividend payments and fluctuating stock prices. As such, companies seek to produce earnings per share amounts that rise each period. However, an increase in earnings per share may not always reflect favorable performance, as there are multiple reasons that earnings per share may increase. One way earnings per share can increase is through increased net income. On the other hand, it can also increase when a company buys back its own shares of stock.

For example, assume that Clear Lake Sporting Goods generated net income of $30,000 and paid out $3,000 in preferred shareholder dividends last year. In addition, 10,550 shares of common stock were outstanding throughout the entire year. In January of the current year, the company buys back shares of its common stock and holds them as treasury shares, making its current weighted average shares outstanding for this year 8,000. Net income for the current year is $35,000, $5,000 of which was paid to preferred shareholders in dividends. In the prior year, the company’s earnings per share was

Earnings per Share=$30,000-$3,00010,550=$2.56Earnings per Share=$30,000-$3,00010,550=$2.56

Clear Lake Sporting Goods’ current year earnings per share is

Earnings per Share=$35,000-$5,0008,000=$3.75Earnings per Share=$35,000-$5,0008,000=$3.75

The purchase of treasury stock in the current year reduces the common shares outstanding to 8,000 because treasury shares are considered issued but not outstanding. Earnings per share for the current year is now $3.75 per share even though earnings only increased by $5,000. It’s key to note the impact of purchasing treasury stock and the intentions in doing so. Treasury stock is commonly purchased for a variety of reasons, but doing so to intentionally manipulate earnings per should not be a primary reason.

This increase in earnings per share occurred because the net income is now spread over fewer shares of stock. Similarly, earnings per share can decline even when a company’s net income increases if the number of shares increases at a higher degree than net income.

Concepts In Practice

Stock Buybacks Can Drive Up Earnings per Share: Ethical?

As many companies struggled to make ends meet or meet their cash flow needs amid the COVID-19 pandemic, some companies continued to thrive. Apple continued to have a healthy financial position with ample cash supply. It repurchased $18.5 billion of its own stock in the second quarter of 2020.1 The total stock buyback over the preceding five years was $282.87 billion, which is 3.5 times higher than any other company. Since the earnings per share calculation is earnings divided by average outstanding shares, the fewer shares there are outstanding, the higher earnings per share goes without the firm having to actually raise earnings.

What do you think? Did Apple act ethically in repurchasing large quantities of its own shares? Is it ethical for any company to do so? If you were an investor or analyst, what questions would you ask or what cautions would you take in assessing and comparing earnings per share data?

(sources: Wayne Duggan. “7 S&P 500 Companies with Stock Buybacks.” US News & World Report. December 14, 2020. https://money.usnews.com/investing/stock-market-news/slideshows/s-p-500-companies-with-stock-buybacks?slide=2; “Apple’s $460 Billion Stock Buyback.” Above Avalon. April 23, 2020. https://www.aboveavalon.com/notes/2020/4/23/apples-460-billion-stock-buyback; “Apple Stock Buybacks (Quarterly).” Ycharts. n.d. https://ycharts.com/companies/AAPL/stock_buyback)

To put a firm’s earnings per share into perspective and allow for a more meaningful analysis, earnings per share is often tracked over a number of years, such as when presented in the comparative income statements for Clear Lake Sporting Goods (see Figure 6.7).

A financial statement for Clear Lake Sporting Goods shows comparative year-end income statements, comparing the current year, the prior year, and 2 years prior. Respectively, net sales is $120,000, $100,000 and $90,000. Cost of goods sold and gross profit are $60,000, $50,000 and $45,000. Rent expense for the current year is $5,500; for the other two years rent is $5,000. Depreciation expense is $3,600, $2,500 and $2,000. Salaries expense is $5,400, $3,000 and $2,750. Utility expense is $2,500, $1,500 and $1,250. Operating Income is $43,000, $38,000 and $34,000. Interest expense is $2,000, $3,000 and $2,000. Income tax expense is $6,000, $5,000 and $5,000. Net income is $35,000, $30,000 and $27,000. The Basic weighted shares outstanding is 8,000, 10,550 and 11,100. Basic net income per share (EPS) is $3.75, $2.56 and $2.21. Common dividends is $6,000, $4,000 and $3,500. Preferred dividends is $5,000, $3,000 and $2,500.
Figure 6.7 Comparative Year-End Income Statements Earnings per share year after year can be a good indication of a company’s financial health.

Most analysts believe that a consistent improvement in earnings per share year after year is an indication of continuous improvement in the earning power of a company. This is what is seen in Clear Lake Sporting Goods’ earnings per share amounts over each of the three years reported, moving from $2.21 to $2.56 to $3.75. However, it is important to remember that earnings per share is calculated on historical data, which is not always predictive of the future.

Think It Through

Would You Have Invested?

What if, in 1997, you invested $5,000 in Amazon? Today, your investment would be worth nearly $6 million. Potential investors viewing Amazon’s income statement in 1997 would have seen earnings per share of negative $1.27. In other words, Amazon lost $1.27 for each share of common stock outstanding. Would you have invested?

Price/Earnings (P/E) Ratio

The price/earnings (P/E) ratio measures the current market share price of a company’s stock relative to its earnings per share (EPS). The ratio is helpful in comparing performance and stock price of a company to other companies. It’s also helpful in evaluating how much investors are willing to pay for earnings performance. Investors, in particular, use this ratio and rely on two key characteristics: past performance (trailing) and future estimates (forward). Trailing data can be calculated but is also easily found online, as it’s a common measure reported on financial sites. Investors will often look for P/E TTM, which is the price/earnings ratio for the trailing 12 months (last year worth of earnings data). This helps investors assess one day’s stock price relative to the earnings per share over the past 12 months. P/E ratio is widely used by investors to determine if a stock is over- or undervalued. It also helps them compare one firm to that of the industry average or index, such as the S&P 500.

Price/Earnings Ratio=Market Value per ShareEarnings per SharePrice/Earnings Ratio=Market Value per ShareEarnings per Share

In the prior section we saw earnings per share data for Clear Lake Sporting Goods. Using its current year earnings per share of $3.75 and the current stock price of $69.41, we can calculate price/earnings ratio for Clear Lake Sporting Goods:

Price Earnings Ratio=$69.41$3.75=18.51Price Earnings Ratio=$69.41$3.75=18.51

An 18.51 ratio means an investor would expect to invest $18.51 to gain $1 of earnings.

Book Value per Share

Book value per share is often used hand in hand with market value per share. Investors compare the two in order to see if the stock is possibly over- or undervalued. Book value is derived from accounting practices and shows the value of the firm on paper. Market value, on the other hand, is determined by supply and demand, based on what investors are willing to pay for the stock. If the market value per share is higher than the book value, the stock is considered overvalued. If the market value is lower than the book value, it’s considered undervalued.

In theory, book value per share represents the total value common shareholders would receive if the firm were liquidated. It is total equity less preferred equity, spread across the total shares outstanding. The formula to calculate book value per share is

Book Value per Share=Total Equity  Preferred EquityTotal Shares OutstandingBook Value per Share=Total Equity  Preferred EquityTotal Shares Outstanding

The book value per share for Clear Lake Sporting Goods is

Book Value per Share=$100,000-$20,0008,000=$10Book Value per Share=$100,000-$20,0008,000=$10

If investors compared the book value per share of $10.00 for Clear Lake Sporting Goods to the P/E ratio of $18.51, they would likely conclude that the stock was undervalued in the year of analysis.

Footnotes

  • 1Bill Maurer. “Apple: New Highs Seem Likely.” Seeking Alpha. May 11, 2020. https://seekingalpha.com/article/4346246-apple-new-highs-seem-likely
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