Chapter 14 Financial Statement Analysis 651Earnings per share is difficult to interpret by itself. Rather, it should be compared to
historical EPS trends and the stock price of a firm, as shown with the price-earnings
ratio in the next section.Price-Earnings Ratio
Another profitability measure quoted by the financial press is the price-earnings (P/E)
ratioon common stock. The price-earnings ratio indicates a firm’s future earnings
prospects. It is computed by dividing the market price per share of common stock at
a specific date by the annual earnings per share. To illustrate, the market prices per
common share on March 1, 2005, for Pixar and DreamWorks were $90.06 and $37.44,
respectively. Thus, the price-earnings ratio on common stock is computed as follows:Pixar DreamWorks
Market price per share of common stock $90.06 $37.44
Earning per share on common stock ÷ $ 2.50 ÷ $ 4.09
Price-earnings ratio on common stock 36.02 9.15The price-earnings ratio indicates that a share of common stock of Pixar sold for 36.02 times
earnings, while for DreamWorks it was only 9.15 times earnings. At the time, the market
average was approximately 16 times earnings. This means that market participants were
optimistic about the future performance of Pixar and were willing to price the common
stock at a premium on the underlying earnings per share. The price of DreamWorks’ com-
mon stock appears to be discounted to the overall market because market participants be-
lieved that DreamWorks’ earnings would decline from the historical performance of 2004.Dividend Yield
Since the primary basis for dividends is earnings, dividends per share and earnings
per share on common stock are commonly used by investors in assessing alternative
stock investments. However, neither Pixar nor DreamWorks pays dividends.
Dividends per share can be reported with earnings per share to indicate the rela-
tionship between dividends and earnings. The ratio of these two per-share amounts,
called the dividend payout ratio, indicates the extent to which the corporation is paying
dividends to stockholders, versus retaining earnings for future growth. Since Pixar and
DreamWorks pay no dividends, they are retaining all their earnings for future growth,
and hence, have a zero dividend payout ratio.
Thedividend yieldon common stock shows the rate of return to common stock-
holders in terms of cash dividends. It is of special interest to investors whose main in-
vestment objective is to receive current returns (dividends) on an investment, rather
than an increase in the market price of the investment. The dividend yield is computed
by dividing the annual dividends paid per share of common stock by the market price
per share on a specific date. Again, Pixar and DreamWorks offer no dividend yield.
Shareholders anticipate low or no dividend yield for growth companies, because they
expect reinvested earnings to return market price increases.SUMMARY OF ANALYTICAL MEASURES
Exhibit 8 presents a summary of the financial ratios that we have discussed for Pixar,
DreamWorks, and the motion picture industry as a whole. Depending on the specific
business being analyzed, some measures might be omitted or additional measures
could be developed. The type of industry, the capital structure, and the diversity of theSummarize the uses and
limitations of analytical
measures.