Financial Accounting: An Integrated Statements Approach, 2nd Edition

MARKET-BASED FINANCIAL MEASURES

Two ratios used by investors to compare the market price of common stock to an

accounting measure are the price-earnings ratio and the market-to-book-value

ratios.

Price-Earnings Ratio

A firm’s growth potential and future earnings prospects are indicated by how much

the market is willing to pay per dollar of a company’s earnings. This ratio, called the

price-earnings ratio, or P/E ratio, is commonly included in stock market quotations re-

ported by the financial press. A high P/E ratio indicates that the market expects high

growth and earnings in the future. Likewise, a low P/E ratio indicates lower growth

and earnings expectations.

The price-earnings ratio on common stock is computed by dividing the stock’s

market price per share at a specific date by the company’s annual basic earnings per

share, as shown below.

Price-Earnings Ratio 

Market Price per Share of Common Stock

Earnings per Share of Common Stock (basic)

Investors that invest in high price-earnings-ratio companies are often referred to

asgrowthinvestors. Growth investors pay a high price for shares because they expect

the company to grow and provide a superior return. That is, high price-earnings ratios

can be related to investor optimism. Examples of growth companies are eBay Inc.(P/E

99),Red Hat, Inc.(P/E 53), and Genentech, Inc.(P/E 65). Growth companies are con-

sidered risky because high growth expectations are already reflected in the market

552 Chapter 12 Special Income and Investment Reporting Issues

2014

June 30 Investment in Deitz Corporation Bonds 474

Interest Revenue 474

Amortized discount for current year.a

30 Cash 48,350

Loss on Sale of Investments 992

Interest Revenue 1,000

Investment in Deitz Corporation Bondsb 48,342

Received interest and proceeds from

sale of bonds.

Interest for April 1 to June 30 

$50,0008% 12 ––^3 $1,000

Compute and interpret

the price-earnings and

price-book ratios.

5

Calculations:

a$796 months $ 474

bCarrying amount of bonds on January 1, 2014 $47,868

Discount amortized, January 1 to June 30, 2014 474

cCarrying amount of bonds on June 30, 2014 $ 48,342

Proceeds of sale 47,350

Loss on sale $ 992

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