Profitability Analysis and Analytical Issues Paper 3
The equity section of Jones Corporation’s statement of financial position is presented below:
Preferred stock, 6%, $100 par $40,000,000
Common stock, $4 par $10,000,000
Additional paid-in capital $20,000,000
Retained earnings $10,000,000
The preferred stock is cumulative and nonparticipating. All preferred dividends have been paid, and liquidation value is $110 per preferred share. What is the book value per share of Jones Corporation’s common stock?
Answer (C) is correct. The liquidation value of the preferred stock is $44,000,000 ($40,000,000 × 1.1). The book value per common share equals the net assets (equity) attributable to common shareholders divided by the common shares outstanding, or $14.40 [($80,000,000 total equity – 44,000,000 preferred equity) ÷ ($10,000,000 common stock ÷ $4 par) common shares].
Which one of the following statements about the price-earnings (P/E) ratio is true?
Answer (A) is correct. A company with high growth opportunities typically has a high P/E ratio because investors are willing to pay a price for the stock higher than that justified by current earnings. In effect, they are trading current earnings for potential future earnings.
Information concerning Hamilton’s common stock is presented below for the fiscal year ended May 31, Year 2.
Common stock outstanding 750,000
Stated value per share $15.00
Market price per share 45.00
Year 1 dividends paid per share 4.5
Year 2 dividends paid per share 7.5
Basic earning per share 11.25
Diluted earnings per share 9.0
The price-earnings ratio for Hamilton’s common stock is
Answer (C) is correct. The price-earnings ratio is calculated by dividing the current market price of the stock by the earnings per share Thus Hamilton’s price-earnings ratio is 4.0 ($45 market price ÷ $11.25 BEPS).
The following information is provided about the common stock of Evergreen, Inc., at the end of the fiscal year:
Number of shares outstanding 1,800,000
Par value per share $ 10.00
Dividends paid per share (last 12 months) 12.00
Market price per share 108.00
Basic earnings per share 36.00
Diluted earnings per share 24.00
The price-earnings ratio for Evergreen’s common stock is
Answer (A) is correct. The price-earnings ratio is (market price/EPS)
For Evergreen, the calculation is $108 ÷ $36 = 3.
Information concerning the common stock of Morris Company as of November 30, the end of the company’s current fiscal year is presented below
Number of shares outstanding 460,000
Par value per share $ 5.0
Dividends paid per share in current year 6.00
Market price per share 54.00
Basic earnings per share 18.00
Diluted earnings per share 12.00
The price-earnings ratio for Morris Company’s common stock is
Answer (B) is correct. The figure of 3.0 times is calculated using the $18.00 basic earnings per share. The formula for the price-earnings ratio is market price per share divided by book earnings per share.
Kevlin, Inc., has 250,000 shares of $10 par value common stock outstanding. For the current year, Kevlin paid a cash dividend of $3.50 per share and had earnings per share of $4.80. The market price of Kevlin’s stock is $34 per share Kevlin’s price-earnings ratio is
Answer (C) is correct. The price-earnings ratio is the market price of the common stock per share divided by earnings per share Kevlin’s is thus 7.08 ($34÷$4.85)
A steady drop in a firm’s price-earnings ratio could indicate that
Answer (A) is correct. Earnings per share is the denominator of the price-earnings ratio. An increase in the denominator while the numerator remains the same results in a fall in the overall ratio.
At year end, Appleseed Company reported net income of $588,000. The company has 10,000 shares of $100 par value, 6% preferred stock and 120,000 shares of $10 par value common stock outstanding and 5,000 shares of common stock in treasury. There are no dividend payments in arrears, and the market price per common share at the end of the year was $40. Appleseed’s price-earnings ratio is
Answer (B) is correct. The price-earnings ratio is the market price of the common stock per share divided
by earnings per share. To arrive at income available to common shareholders, dividends on preferred stock must be subtracted from net income [$588,000 – (10,000 preferred shares × $100 par value × 6%) = $528,000], making the per-share amount $4.40 ($528,00 ÷ 120,000 common shares Appleseed’s price-earnings ratio is thus 9.09 ($40 ÷ $4.40).
Archer, Inc., has 500,000 shares of $10 par value common stock outstanding. For the current year, Archer paid a cash dividend of $4.00 per share and had earnings per share of $3.20. The market price of Archer’s stock is $36 per share The average price-earnings ratio for Archer’s industry is 14.00 When compared to the industry average Archer’s stock appears to be
Answer (D) is correct. The price-earnings ratio is the market price of the common stock per share divided by earnings per share Archer’s price-earnings ratio is thus 11.25 ($36 ÷ $3.20). The difference between this ratio and the industry average is 2.75, an undervaluation of 24.4% (2.75 ÷ 11.25).
When reviewing a credit application, the credit manager should be most concerned with the applicant’s
Answer (D) is correct. Liquidity is a firm’s ability to pay its current obligations as they come due and thus remain in business in the short run. This is the area of most concern when considering granting credit to a customer.