Using Your Judgment 4-5 One of the more closely watched ratios by investors is t

Question

Using Your Judgment 4-5

One of the more closely watched ratios by investors is the price/earnings (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 = price per share ÷ 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. [Source: Janice Revell, “Beyond P/E,” Fortune (May 28, 2001), p. 174.]

(b)

Compute the P/E ratio and the PSR for Tootsie Roll and Hershey for 2011. (Round P/E values to 1 decimal place, e.g. 52.5 and PSR values to 2 decimal places, e.g. 52.23.)

Explanation / Answer

PE ratio = MP/EPS Tootsie Roll hershey MP 32.26 40 EPS 0.68 0.75 PE ratio = MP/EPS 47.44117647 53.33333333 PSR= price per share/ sales per share MP 32.26 50 SPS: 8.172344997 13.2 PSR = 3.94745939 Sales per share: Sales 532.51 M 65.16 M SPS: 8.172344997

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