Chapter 4: The Value of Common Stocks
Number 1
Earnings per ratio (EPS) entails the firm’s profit divided by the outstanding shares of the common stock in a specific duration. The figure or the answer indicates the organisation’s profitability. EPS also entails the amount of money that the company makes for every share of its stock. Besides profitability, it is applied to assess the firm’s value. A high EPS indicates the more profitable a company is, which is essential for the investors who will be willing to pay more for the shares if there are higher profits in relation to the share price (Fernando, 2022b). There are several aspects to consider when arriving at the EPS value. These include terminated relationships and extraordinary elements. The EPS formula is provided below. Notably, the weight average shares outstanding can also be replaced by the end of period shares outstanding. The weighted average is preferred since the shares may change with time.
A key element to note is that a single EPS value for a company is a bit arbitrary. The figure is valuable if it has been analysed based on other organisations in the industry and if it is compared to the firm’s share price, which reflects the significant relationship between the EPS and the P/E ratio. When the EPS of at least two companies in the same industry are compared, the one with the highest figure presents as the most profitable, which is vital for the investors.
Number 2
Profitable firms return the excess money to the shareholders through dividends. Also, they can reward the investors through stock buybacks. This refers to the use of cash to purchase shares of its stock in an open market. The decision is aimed at several aspects, including returning cash to the shareholders that it does not require for other investments or fund operations. The primary reason why organisations purchase their own stock from the investors is to promote value for the stakeholders (Curry and Schmidt, 2022). Value in this regard entails increasing the share price. The economics of buybacks is that in instances where the demand for the firm’s shares is high, there is an increase in the stock prices. When the firm purchases its shares, it assists in raising the stock prices through boosting the demands. This creates value for every shareholder. Companies benefit through increased brand name and value.
The impacts of buyback on the firm’s value are reflected in the financial fundamentals. When companies’ buyback, they remove the cash from the balance sheet, reducing the shares outstanding. The impacts on the value is that in metrics such as EPS, which are calculated by the net profit divide by the number of shares outstanding, the figure is higher when the shares have been removed (Segal., 2021). This reflects on the company appearing to be performing well. Similarly, the price-to-earnings (P/E) ratio is also affected by the buyback. Investors evaluate the firm’s value by comparing the EPS and stock prices, although the buyback should be critically considered to avoid the poor cash sage.
Number 3
Price-earnings (PE) ratio refers to the ratio of the firm’s share price to the earnings per share (EPS). The PE ratio is important in valuing organisations to determine if the firms are being undervalued or overvalued. Essentially, the PE ratio shows the number of dollars an investor expects to use in an organisation to get one dollar of the earnings. This is the foundation of the PE being referred to as price multiple or earnings multiple (Fernando, 2021). This is based on the fact that PE demonstrates the amount that investors may be willing to pay per every dollar of the total earnings. The PE ratio is provided below;
Analysts and investors apply the PE ratio to work out the relative value of the firm’s shares. The PE ratio can also be applied to compare the firm against its record or compare the markets against each other or over a certain duration. Another key aspect of the PE ratio is that it can be estimated by looking backward or projected context. The importance of the PE ratio is reflected in the business cycle. Notably, there are instances where investors and analysts are interested in the valuation trends over the long-term. They, therefore, consider a 10 or 30 years PE, referred to as PE 10 or PE 30, respectively. These measures are critical in compensating for the long-term changes in the business cycle. Investors also use PE to ascertain the accurate representation of the share price and EPS.
Number 4……
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