Financial Statement Analysis Page 20
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51Financial Statement Analysis
741
increasing profits during good times but compounding losses during bad times.
Compare Greg’s Tunes’ rate of return on common stockholders’ equity with the
industry average of 10.5%. Once again, Greg’s Tunes is performing much better than
the average company in its industry. A rate of return on common stockholders’
equity of 15%–20% year after year is considered good in most industries. At 14.2%,
Greg’s is doing well.
Earnings per Share of Common Stock
Earnings per share of common stock, or simply earnings per share (EPS), is perhaps
the most widely quoted of all financial statistics. EPS is the only ratio that must
appear on the face of the income statement. EPS is the amount of net income earned
for each share of the company’s outstanding common stock. Recall that
Outstanding stock = Issued stock – Treasury stock
Earnings per share is computed by dividing net income available to common
stockholders by the number of common shares outstanding during the year. Preferred
dividends are subtracted from net income because the preferred stockholders have
the first claim to dividends. Greg’s Tunes has no preferred stock outstanding and,
therefore, paid no preferred dividends.
The firm’s EPS for 2014 and 2013 follow. (Note that Greg’s had 10,000 shares
of common stock outstanding throughout both years.)
Greg’s Tunes’ Earnings per Share
Industry
Formula
2014
2013
Average
Net
Preferred
–
Earnings per
income
dividends
$48,000 – $0
$26,000 – $0
share of
=
= $4.80
= $2.60
$9.76
Number of shares
10,000
10,000
common stock
of common stock
outstanding
Greg’s Tunes’ EPS increased significantly in 2014 (by almost 85%). Its stock-
holders should not expect this big a boost in EPS every year. Most companies strive
to increase EPS by 10%–15% annually, and leading companies do so. But even the
most successful companies have an occasional bad year. EPS for the industry at
$9.76 is a little over twice Greg’s Tunes’ 2014 EPS. Therefore, Greg’s Tunes needs to
work on continuing to increase EPS so that it is more competitive with other compa-
nies in its industry.
Evaluating Stock Investments
Investors purchase stock to earn a return on their investment. This return consists of
two parts: (1) gains (or losses) from selling the stock at a price above (or below) pur-
chase price and (2) dividends. The ratios we examine in this section help analysts
evaluate stock investments.
Price/Earnings Ratio
The price/earnings ratio is the ratio of the market price of a share of common stock
to the company’s earnings per share.
The price/earnings ratio shows the market price
of $1 of earnings.
This ratio, abbreviated P/E, appears in the Wall Street Journal
stock listings.
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