Chapter 11: Decision Analysis: Earnings per Share, Price-Earnings Ratio, and Dividend Yield

Analyzing Earnings per Share (EPS), Price-Earnings Ratio (PE), and Dividend Yield Understanding these metrics helps investors assess company performance, value, and potential returns on investment. 1. Earnings per Share (EPS) • • • Definition: EPS measures the income earned per share of common stock. It is calculated as follows: EPS=Net Income−Preferred DividendsWeightedAverage Common Shares Outstanding Example: If Quantum Co. has a net income of $40,000 and pays $7,500 in preferred dividends with 5,000 common shares outstanding, the EPS calculation would be: EPS=40,000−7,5005,000=6.50 Interpretation: Higher EPS indicates higher profitability per share, making it a key measure of financial health and attractiveness to investors. 2. Price-Earnings (PE) Ratio • • • Definition: The PE ratio compares a company’s market price per share to its EPS. The formula is: PE Ratio=Market Value per ShareEarnings per Share (EPS) Interpretation: The PE ratio shows the price investors are willing to pay for each dollar of current earnings. A high PE ratio may indicate high growth expectations, while a low PE ratio could suggest undervaluation or slower growth prospects. Example: Visa and Mastercard have high PE ratios, reflecting investor confidence in their future earnings. If Mastercard has a higher PE than Visa, this suggests the market may have slightly higher expectations for Mastercard’s growth. 3. Dividend Yield • Definition: Dividend yield measures the annual dividend relative to the stock price, reflecting the cash return on investment for dividend-seeking investors. It is calculated as follows: Dividend Yield=Annual Cash Dividends per ShareMarket Value per Share • Example: Companies like Altria with high dividend yields (e.g., 7%) are often income stocks, appealing to investors interested in regular income. Conversely, a growth stock like Amazon has a dividend yield of zero, indicating that investors expect returns primarily through stock price appreciation. • Interpretation: A high dividend yield suggests the stock may provide stable income, while a low or zero dividend yield indicates potential growth in stock value rather than cash payouts. Example Application for Barton Corporation Transactions in Year 1 and Year 2: 1. Authorized Stock: o Common stock: 2 million shares at $5 par value. o Preferred stock: 100,000 shares at $100 par value with a 10% cumulative dividend. 2. Issuance of Stock: o Issued 200,000 shares of common stock at $12 per share. o Issued 100,000 shares of common stock for a building and inventory valued at $1.2 million total. o Paid founders $10,000 for organization activities. o Issued 12,000 preferred shares at $110 per share. o In Year 2, issued an additional 100,000 shares of common stock at $15 per share. Dividend Allocation: • • Year 1 Dividend: $50,000. o Preferred stockholders are entitled to a 10% dividend on $100 par value, or $10 per share, totaling $120,000 for 12,000 preferred shares. o Since only $50,000 was declared, this amount will go to preferred stockholders, leaving no dividend for common stockholders. o The remaining $70,000 of preferred dividends will carry over as dividends in arrears due to the cumulative nature of the preferred stock. Year 2 Dividend: $300,000. o Preferred stockholders receive $120,000 for the current year plus $70,000 in arrears from Year 1, totaling $190,000. o Common stockholders receive the remaining $110,000 in dividends. Journal Entries for Selected Transactions 1. Issuing 200,000 Shares of Common Stock at $12 per Share (January 2): o a. If common stock is no-par stock without a stated value: plaintext Debit Cash $2,400,000 Credit Common Stock $2,400,000 o b. If common stock is no-par stock with a stated value of $10 per share: plaintext Debit Cash $2,400,000 Credit Common Stock $2,000,000 Credit Paid-In Capital in Excess of Stated Value $400,000 2. Issuing Preferred Stock (12,000 shares at $110 per share): plaintext Debit Cash $1,320,000 Credit Preferred Stock $1,200,000 Credit Paid-In Capital in Excess of Par Value, Preferred Stock $120,000 3. Dividend Allocation Table: Year Dividends Declared Preferred Dividends Common Dividends Dividends in Arrears Year 1 $50,000 $50,000 $0 $70,000 Year 2 $300,000 $190,000 $110,000 $0 These metrics and journal entries give insight into how companies allocate earnings, dividends, and maintain accurate records of equity transactions and shareholder distributions.