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Chapter 4: Problem 5

A company has an EPS of \(\$ 2.00\), a cash flow per share of \(\$ 3.00\) and a price/cash flow ratio of \(8.0 \times .\) What is its \(\mathrm{P} / \mathrm{E}\) ratio?

Short Answer

Expert verified
The P/E ratio is 12.0.

Step by step solution

01

Understand the Given Information

We are given the earnings per share (EPS) which is \( \\(2.00 \), the cash flow per share which is \( \\)3.00 \), and the price/cash flow ratio of \( 8.0 \times. \) We need to find the price/earnings ratio (P/E ratio).
02

Calculate the Stock's Price Using the Price/Cash Flow Ratio

We use the formula for the price/cash flow ratio: \( \text{Price} = \text{Cash Flow per Share} \times \text{Price/Cash Flow Ratio}. \) Substituting the given values, we have: \[ \text{Price} = 3.00 \times 8.0 = \$24.00. \]
03

Use the Calculated Price to Find the P/E Ratio

Now, we use the price that we found to calculate the P/E ratio. The formula is: \( \text{P/E Ratio} = \frac{\text{Price}}{\text{EPS}}. \) Substituting the values, we have: \[ \text{P/E Ratio} = \frac{24.00}{2.00} = 12.0. \]
04

Conclusion

The P/E ratio of the company is \( 12.0 \). This tells us how much investors are willing to pay per dollar of earnings.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Understanding Earnings Per Share (EPS)
Earnings Per Share (EPS) is a key financial metric that gives insight into a company's profitability on a per-share basis. It is calculated by taking the company's net income and dividing it by the number of outstanding shares. This metric is crucial because it provides a direct indication of a company's profitability.
  • Basic Calculation: EPS is calculated using the formula: \[\text{EPS} = \frac{\text{Net Income}}{\text{Number of Outstanding Shares}}\]
  • Significance: A higher EPS indicates that a company is more profitable, which is usually attractive to investors. It implies that the company is generating more earnings per share, which could lead to higher dividends.
  • Types of EPS: It's important to differentiate between basic EPS and diluted EPS. Basic EPS doesn't account for any potential shares that might arise from options or convertible securities. Diluted EPS considers these potential shares, providing a more conservative view of EPS.
EPS is a foundational component for calculating other financial ratios, such as the price/earnings ratio, which we'll discuss next.
Deciphering the Price/Earnings Ratio (P/E Ratio)
The Price/Earnings Ratio (P/E Ratio) is a valuation measure used to assess a company's relative value. It is computed by dividing the current market price per share by the earnings per share (EPS).
  • Calculation Formula: The P/E ratio is calculated as follows:\[\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{Earnings per Share (EPS)}}\]
  • Interpretation: A high P/E ratio might suggest that a stock is overvalued, or investors expect high growth rates in the future. Conversely, a low P/E might indicate that the stock is undervalued or the company is experiencing difficulties.
  • Use in Investment Decisions: Investors use the P/E ratio to compare the relative price of a company's shares. This comparison can be made against the company's own historical P/E, industry averages, or broader market indices.
Understanding the P/E ratio helps investors gauge the market's expectations of a company's future earnings, guiding more informed investment choices.
Exploring Cash Flow Per Share
Cash Flow Per Share is another vital measure of a company's financial performance. While EPS focuses on accounting profit, cash flow per share gives a clearer picture of cash generation ability.
  • Formula: Cash flow per share is calculated by dividing the total cash flow from operations by the number of outstanding shares:\[\text{Cash Flow Per Share} = \frac{\text{Cash Flow from Operations}}{\text{Number of Outstanding Shares}}\]
  • Importance Over Earnings: Cash flow per share is considered by many analysts as a more reliable indicator of a company's financial health. This is because cash flow is less susceptible to accounting adjustments and provides a clearer view of the actual cash a company can use.
  • Difference from EPS: The key difference is that cash flow per share considers actual cash availability, while EPS includes non-cash charges and may not reflect the spendable income.
By examining cash flow per share, investors can understand a company's financial stability and its ability to generate cash, which is crucial for sustaining operations and funding future growth.

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Most popular questions from this chapter

Baker Brothers has a DSO of 40 days, and its annual sales are \(\$ 7,300,000 .\) What is its accounts receivable balance? Assume that it uses a 365-day year.

Ebersoll Mining has \(\$ 6\) million in sales, its \(\mathrm{ROE}\) is \(12 \%\), and its total assets turnover is \(3.2 \times .\) The company is \(50 \%\) equity financed. What is its net income?

Harrelson Inc. currently has \(\$ 750,000\) in accounts receivable, and its days sales outstanding (DSO) is 55 days. It wants to reduce its DSO to 35 days by pressuring more of its customers to pay their bills on time. If this policy is adopted, the company's average sales will fall by \(15 \%\). What will be the level of accounts receivable following the change? Assume a 365 -day year.

AEI Incorporated has \(\$ 5\) billion in assets, and its tax rate is \(40 \%\). Its basic earning power (BEP) ratio is \(10 \%\), and its return on assets (ROA) is 5\%. What is AEI's timesinterest-earned (TIE) ratio?

Central City Construction (CCC) needs \(\$ 1\) million of assets to get started, and it expects to have a basic earning power ratio of \(20 \% .\) CCC will own no securities, so all of its income will be operating income. If it so chooses, CCC can finance up to \(50 \%\) of its assets with debt, which will have an \(8 \%\) interest rate. Assuming a \(40 \%\) tax rate on all taxable income, what is the difference between CCC's expected ROE if it finances with \(50 \%\) debt versus its expected \(\mathrm{ROE}\) if it finances entirely with common stock?
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