Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 12 Special Income and Investment Reporting Issues 553

price. Thus, if the company’s high growth expectations are not realized, the stock price

will likely fall.

In contrast, investors in low price-earnings-ratio companies are often referred to as

valueinvestors. Value investors seek companies with stable and predictable earnings.

The value investor believes that the low price-earnings ratio investment is safer than

high price-earnings investments, since the stock is priced at a “bargain” level. Value

investing is generally considered the “tortoise” emphasis to the growth investor’s

“hare” emphasis. Examples of value stocks are Bank of America(P/E 12.5), U.S. Steel

(P/E 6.2), and General Motors(P/E 5.6).

To illustrate the calculation and analysis of the price-earnings ratio, consider the

following market price per share, earnings per share, and price-earnings ratio infor-

mation for eBay Inc.

Market Price Earnings per Price-Earnings

Dec. 31 per Share Share (Basic) Ratio

2002 1 33.91 0.43 79 ($33.91/$0.43)

2003 1 64.61 0.69 94 ($64.61/$0.69)

2004 116.34 1.18 99 ($116.34/$1.18)

As can be seen, eBay’s price-earnings ratio has increased over the three-yearperiod.

Apparently, investors increased their growth expectations for this company, and the

price-earnings ratio increased accordingly. This expectation is not without merit. Over

the three-year period, earnings per share grew by 174% [(1.18 0.43)/0.43]. The price-

earnings ratio for eBay can be compared to the price-earnings ratio of a market index,

such as the Standard & Poor’s 500®.^12 Exhibit 5 shows a graph of eBay’s price-earnings

ratio plotted with the price-earnings ratio of the Standard & Poor’s 500 index. The

exhibit shows that eBay’s price-earnings ratio is much greater than the broader market,

reflecting eBay’s growth potential. Over this time period, eBay’s price-earnings ratio

actually increased, while the broader market declined.

12 The Standard & Poor’s 500 index is an index of the largest 500 companies in the United States. The

price-earnings ratio for the index is determined by dividing the market price of the index by the total

earnings per share of all the stocks within the index. This P/E ratio is a broad gauge of the market as a

whole.

Exhibit 5

Price-Earnings Ratios
for eBay and the
Standard & Poor’s
500 Index

2002 2003 2004

0

20

40

60

80

120

100

eBay

S&P

P/E Ratio

Source:MarketGauge®.