Question

A company reported net income of $6 million. During the year the average number of common shares outstanding was 3 million. The price of a share of common stock at the end of the year was $5. There were 400,000 shares of preferred stock outstanding on average and no dividends were declared and the preferred stock is noncumulative. The EPS is approximately: a.$0.40. b.$1.76. c.$1.86. d.$2.00. The Price/Earnings ratio is approximately: a.2.00. b,2.50. c,2.84. d.12.50. Price to Earnings Ratio (P/E): The price to earnings ratio (P/E) is used a relative valuation or multiple for shares of stock. The multiple is based on earnings per share (EPS). So, if a company has a PE ratio of 2, it means the share price is trading at 2 times earnings. If the PE ratio is 20, it means the share price is trading at 20 times earnings. Since earnings are earnings, the PE ratio acts like a price tag. Some companies have a higher share price for the same level of earnings. Why

Answer 1

The EPS is approximately:

it can be any of them:

• if preferred dividends = $4,800,000, then EPS = $0.40 (option A)
• if preferred dividends = $720,000, then EPS = $1.76 (option B)
• if preferred dividends = $0, then EPS = $2 (option D)

EPS = (net income - preferred dividends) / outstanding shares = ($6,000,000 - preferred dividends) / 3,000,000 shares

The Price/Earnings ratio is approximately:

• if EPS = $0.40, then PE ratio = 12.5 (option D)
• if EPS = $1.76, then PE ratio = 2.84 (option C)
• if EPS = $2, then PE ratio = 2.5 (option B)

Price/earnings (PE) ratio = share price / EPS = $5 / EPS

EPS cannot be $1.80, since PE ratio = 2.78 and that is not an option.

Some companies have a higher share price for the same level of earnings. Why?

Some stocks like Amazon have a very low EPS, form any years its EPS was very low bu its stock price kept rising. The stock price is based mostly on potential future earnings, not current earnings. A company that is being liquidated might have a high EPS, but a very low stock price since it will stop operating soon.