Case: P/E Ratios
One of the more closely watched ratios by investors is the price/earnings or P/E ratio. By dividing price per share by earnings per share, analysts get insight into the value the market attaches to a company’s earnings. More specifically, a high P/E ratio (in comparison to companies in the same industry) may suggest the stock is overpriced. Also, there is some evidence that companies with low P/E ratios are underpriced and tend to outperform the market. However, the ratio can be misleading.
P/E ratios are sometimes misleading because the E (earnings) is subject to a number of assumptions and estimates that could result in overstated earnings and a lower P/E. Some analysts conduct “revenue analysis” to evaluate the quality of an earnings number. Revenues are less subject to management estimates and all earnings must begin with revenues. These analysts also compute the price to sales ratio (PSR 5 price per share 4 sales per share) to assess whether a company is performing well compared to similar companies. If a company has a price to sales ratio significantly higher than its competitors, investors may be betting on a stock that has yet to prove itself.
Instructions
(a) Identify some of the estimates or assumptions that could result in overstated earnings.
(b) Compute the P/E ratio and the PSR for Tootsie Roll and Hershey for 2009.
(c) Use these data to compare the quality of each company’s earnings.
Accounting, Analysis, and Principles
Counting Crows Inc. provided the following information for the year 2012.
|
Retained earnings, January 1, 2012 |
$ 600,000 |
|
Administrative expenses |
240,000 |
|
Selling expenses |
300,000 |
|
Sales revenue |
1,900,000 |
|
Cash dividends declared |
80,000 |
|
Cost of goods sold |
850,000 |
|
Extraordinary gain |
95,000 |
|
Loss on discontinued operations |
75,000 |
|
Rent revenue |
40,000 |
|
Unrealized holding gain on available for sale securities |
17,000 |
|
Income tax applicable to continuing operations |
187,000 |
|
Income tax benefit applicable to loss on discontinued operations |
25,500 |
|
Income tax applicable to extraordinary gain |
32,300 |
|
Income tax applicable to unrealized holding gain on available for sale securities |
2,000 |
Accounting
Prepare (a) a single step income statement for 2012, (b) a retained earnings statement for 2012, and (c) a statement of comprehensive income using the second income statement format. Shares outstanding during 2012 were 100,000.
Analysis
Explain how a multiple step income statement format can provide useful information to a financial statement user.
Principles
In a recent meeting with its auditor, Counting Crows’ management argued that the company should be able to prepare a pro forma income statement with some one time administrative expenses reported similar to extraordinary items and discontinued operations. Is such reporting consistent with the qualitative characteristics of accounting information as discussed in the conceptual framework? Explain.