Question

Cold Goose Metal Works Inc. just reported earnings after tax (also called net income) of $8,500,000, and a current stock price of $23.00 per share. The company is forecasting an increase of 25% for its its after-tax income next year, but it also expects it will have to issue 2,000,000 new shares of stock (raising its shares outstanding from 5,500,000 to 7,500,000).

If Cold Goose's forecasr turns out to be correct and its price-to-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 calculations to four decimal places)

a) $21.07 per share

b) $23.00 per share

c) $15.80 per share

d) $26.34 per share

One year later, Cold Goose's shares are trading at $52.08 per share, and the company reports the values of its total common equity as $31,605,000. Given this information, Cold Goose's market-to-book (M/B) ratio is _______ (fill in the blank)

Is it possible for a company to exhibit a negative EPS and thus a negative P/E ratio?

a) Yes

b) No

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

a) Low P/E ratios could mean that the company has a great deal of uncertainty in its future earnings.

b) High P/E ratios could mean that the company has a great deal of uncertainty in its future earnings.

Answer 1

Question 1

P/E Ratio = Price per Share/Earnings per Share

where, Earnings per Share = Net Income/Number of shares outstanding

Existing P/E Ratio = 23/(8,500,000/5,500,000) = 14.88

Next Year, Net income is expected to grow by 25% = 8,500,000 * (1 + 25%) = 10,625,000

New EPS = 10,625,000/7,500,000 = $1.4167

Company wants P/E to remain constant = 14.88

Hence, price per share expected next year = 14.88 * 1.4167 = $21.07 (Option A. ANSWER)

Question 2

It is not clear if the company raised new shares or not.

Assuming it did raise new shares, M/B Ratio = (Market Value of Equity/Book value of Equity) = (52.08 * 7,500,000)/31,605,000 = 12.36

{If it was not able to raise new shares, M/B Ratio = (52.08 * 5,500,000)/31,605,000 = 9.06}

Question 3

Yes, a company can have a negative EPS and hence a negative P/E ratio.

Negative EPS is possible when the company makes a net loss.

Question 4

Statement a is true.

A stock which has a low P/E ratio does not necessarily mean it is undervalued. It is possible that the company is facing financial troubles, or there is an unceratinty around its earnings momentum or capacity, due to which it is not in much demand and hence has a lower price which is driver of low P/E.

High P/E may not only mean lower earnings but could also be driven by high price - which might be because company has good growth prospects or market reputation and hence is valued more and in demand than its peers and hence is trading at higher price.