Question

Ratios are mostly calculated using data drawn from the financial statements of a firm. However, another group of ratios, called market value ratios, relate to a firm’s observable market value, stock prices, and book values, integrating information from both the market and the firm’s financial statements.

Consider the case of Green Caterpillar Garden Supplies Inc.:

Green Caterpillar Garden Supplies Inc. just reported earnings after tax (also called net income) of $9,250,000 and a current stock price of $12.00 per share. The company is forecasting an increase of 25% for its after-tax income next year, but it also expects it will have to issue 3,000,000 new shares of stock (raising its shares outstanding from 5,500,000 to 8,500,000).

If Green Caterpillar’s forecast turns out to be correct and its price/earnings (P/E) ratio does not change, what does the company’s management expect its stock price to be one year from now? (Round any P/E ratio calculation to four decimal places.)

$9.71 per share

$12.00 per share

$7.28 per share

$12.14 per share

One year later, Green Caterpillar’s shares are trading at $55.80 per share, and the company reports the value of its total common equity as $16,507,000. Given this information, Green Caterpillar’s market-to-book (M/B) ratio is ______. .

Can a company’s shares exhibit a negative P/E ratio?

No

Yes

Which of the following statements is true about market value ratios?

Companies with high research and development (R&D) expenses tend to have low P/E ratios.

Companies with high research and development (R&D) expenses tend to have high P/E ratios.

Answer 1

Current Earnings per share = Net Income/Number of shares

= 9,250,000/5,500,000

= $1.6818 per share

P/E Ratio = Market price per share/Earnings per share

= 12/1.6818

= 7.1352 times

EPS next year = 9,250,000*1.25/8,500,000

= $1.3603

Stock Price = EPS*P/E Ratio

= 1.3603*7.1352

= $9.7059 per share

i.e. $9.71 per share

Book Value per share = 16,507,000/8,500,000 = $1.942

Market to Book value ratio = 55.80/1.942

= 28.7333 times

Companies with high R&D expenses tend to have high P/E Ratios

Since their income is lower but higher potential in future