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?

Yes

No

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

Answer 1 - Net income after 1 year = 9250000 * (1 +25%) = 11562500

New o/s shares after 1 year = 8500000

EPS of Current year = Net income / O/s shares = 9250000/ 5500000 = 1.6818

P/E ratio of Current Year = 7.1351

If P/E ratio remains Same then EPS of forecasted year will be 11562500/8500000 = 1.3602

P/E ratio = Price / Earnings

Therefore Price= P/E ratio * Earnings

Price = 7.1351 * 1.3602 = 9.71

Therefore expected stock price after 1 year will be $9.71

Answer 2 market-to-book (M/B) ratio is Market Capitalization / Total Book Value

Market Cap = Price of Shares * O/s Shares

= 55.8 * 5500000 ( if no new equity raised )

Market Capitalization = 306900000

Total Book Value (given) is 16507000

Therefore M/B ratio = 306900000/16507000 = 18.59 times

Answer 3 Yes, theoretically the P/E ratio can be negative, if the Earnings of that period is in loss.

Thus P/E can be negative as per the formula. In real life the negative P/E ratio of a stock is not justified, thus this does not exist in maket.

Answer 4 - Companies with high research and development (R&D) expenses tend to have low P/E ratios. - The statement is true , because Higher will be the investment in R&D, which would result in lower Earnings thus automatically the P/E ratio will be low.