Learning Outcomes
- Calculate earnings per share and the price-earnings ratio
Earnings per share (EPS) measures the dollar amount of net income associated with each share of common stock outstanding.
In its basic form, the calculation is net income − preferred stock dividends divided by number of shares of common stock outstanding.
Or the formula: [latex]\dfrac{\text{net income} -\text{preferred stock dividends}}{\text{common shares}}[/latex]
Preferred dividends are removed from the net income amount since they are distributed prior to common shareholders having any claim on company profits.
Shares outstanding are usually disclosed on the face of the financial statements. In the case of Jonick, we can figure out the number of shares outstanding even though it isn’t disclosed overtly, by dividing the common stock dollar amount by the par value per share given (83,000 in common stock with a $10 par value would be 8300 shares issued and outstanding).
| Description | 2019 |
|---|---|
| Income before income tax | $314,000 |
| Income tax expense | 66,000 |
| Net income | Single Line$248,000 Double Line |
| Description | 2019 |
|---|---|
| Retained earnings, beginning of year | $2,198,000 |
| Net income | 248,000 |
| Less: Preferred stock dividends | 12,000 |
| Common stock dividends | 8,000 |
| Increase in retained earnings | 20,000 |
| Retained earnings, end of year | Single Line$2,426,000Double Line |
| 2019 | |
|---|---|
| Stockholders’ Equity | |
| Preferred $1.50 stock, $20 par | $166,000 |
| Common stock, $10 par | 83,000 |
| Retained earnings | 2,426,000 |
| Total stockholders’ equity | $2,675,000 |
| Total liabilities and stockholders’ equity | Single Line$3,950,000Double Line |
Therefore, for Jonick Company, EPS would be $248,000 in net income minus $12,000 in preferred stock dividends divided by $8,300 outstanding shares of stock = $28.43 of earnings for each share of stock.
Price Earnings Ratio
Earning per share can also be expressed as a price/earnings ratio by dividing the current price per share by EPS.
If this was a publicly traded company or if there was a readily available market value per share (e.g. an offer to buy the company on the table or a recent purchase), we could also calculate the dividend yield by dividing the dividend per share by the market price per share.
For this example, assume we have an established market price per share of $70.
The P/E ratio would be [latex]\dfrac{70}{28.43} = 2.46[/latex], which indicates that the stock is selling at about 2.5 times earnings. This kind of ratio is only good for comparing one stock to another or to compare a stock against an industry trend. For example, in August 2018, the average P/E ratio of the financial services industry was 14.26. You might consider buying a financial services stock with a market price of $50/share and with a P/E of 10 because that stock is trading at 10 times earnings (so earnings are presumably $5/share). All other things being equal, it should be trading closer to the industry average of 14.26, which would mean you might expect the price to come up to $71.30. In other words, a lower than expected P/E ratio might mean that a stock is under-priced.
Again, as with any metric, EPS and P/E need to be assessed in a broader context. Now let’s practice what you’ve learned.
PRACTICE QUESTIONS
