Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.

14. Financial Statement Analysis

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Ratios: Price-Earnings Ratio (PE Ratio)

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Alright so let's discuss the price earnings ratio. The price earnings ratio usually called the P. E. Ratio. Like we see here P. Over E. Well that's how we're going to calculate it, it's gonna be the price over the earnings. Okay so pe ratio it's a common market value ratio because we're dealing with we're using the actual market value of the stock. So investors use this when they're thinking about investing in a stock. Well how much earnings are they gonna get per dollar that they invest here? Okay. So the price earnings ratio, the an important part of this ratio is the earnings per share. Okay. So a lot of times when we deal with price earnings ratio, they're really just asking you to calculate earnings per share and then do price divided by earnings per share. So the trickiest part of this could be remembering how to calculate earnings per share. All right. So you might want to go back to the earnings per share video if you need more information but let's go ahead and just review it real quick right here. So our earnings per share. Remember it's gonna be net income minus preferred dividends in our numerator. And a lot of times they might not talk about preferred dividends if they don't talk about it, it's gonna be zero. So you might just not have it at all. Okay, so net income minus preferred dividends and in the denominator we've got the average number of shares of common stock outstanding. Alright so that's a lot of words but remember we're talking about a number of shares. So we're not talking about like the dollar value of the shares? Excuse me, the book value of equity or something like that. We're talking about a number of shares, a million shares outstanding, 500,000 shares outstanding, whatever it is. And we're focused on the common stock. Okay. So there could be common shares and preferred shares while we're focused on the common shares that are outstanding. And last it's an average. So like we've done with averages before, remember, it's gonna be the beginning balance plus the ending balance divided by two. Right? That's how we always deal with averages. But remember this is an average with the number of shares. Okay, So we're talking about a number of shares, not a dollar value. So the beginning number of shares plus ending number of shares divided by two. Alright, so that's usually the most complicated part of this formula, because once we get to the price earnings ratio down here below notice the numerator is the price, right? Price divided by earnings. So the numerator is the current market price of a share of common stock. Okay. So they're gonna tell you in the problem though. Usually say the market price is $20 for a share of stock, whatever it is. Okay, and the denominator, is that earnings per share? So market or price divided by earnings. Alright. So how do we use this information? What does this really tell us? It tells us the market price for a dollar of earnings, right? Remember it's how much of the numerator for each one of the denominator. So if there was $1 of earnings, how much would you have to pay for that in market price? Okay. For each dollar of earnings. Cool. So what's the comparison here? Well, you can imagine that investors want to pay as little as possible for as much earnings as they can, right? So they want to price earnings ratio. That's lower the lower the ratio, the more value they're getting for each dollar of earnings so they want to pay as little as possible for those earnings. How If you see a high price earnings ratio of price earnings ratio sometimes reaches as high as 20 times or something like that. You can see really high price earnings ratios. Well this indicates projections of future earnings, right? Because investors remember they're taking into account when they have when the market sets the price with all the demand and supply of the stock. Well, it takes into account all the information that's available. So if investors realize that there's gonna be a lot of future earnings, well, that's going to bump up the price, right? So that price earnings ratio, even though there's currently not as much earnings, it could project that there's gonna be a lot of future earnings. Cool. Alright. So remember the main trick here is remembering how to calculate your earnings per share and then the price earnings ratio while it's just price divided by earnings. Cool. Alright, let's jump into some practice problems for the price earning ratio.

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Problem

MoneyCo had sales revenue and net income during the current year of $500,000 and $60,000, respectively. The total amount of stockholders’ equity was $600,000, and common shares outstanding were 120,000 all year. If the market price of the stock is $10, what is the P/E ratio?

A

5

B

10

C

20

D

40

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Problem

Tougher Company’s current year income statement showed an EPS of $1.25 per share. If total common equity totaled $600,000 (40,000 common shares), preferred dividends were $10,000 (10,000 preferred shares), and the market price of common and preferred stock are $25 and $50, respectively, what is the company’s P/E ratio?

A

5

B

10

C

20

D

40

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