Case 2: P/E Ratios

One of the more closely watched ratios by investors is the price/earnings (P/E) ratio. By dividing price per share by earnings per share, analysts get insight into the value the market attaches to a company's earnings. More specifically, a high P/E ratio (in comparison to companies in the same industry) may suggest the stock is overpriced. Also, there is some evidence that companies with low P/E ratios are underpriced and tend to outperform the market. However, the ratio can be misleading.

P/E ratios are sometimes misleading because the E (earnings) is subject to a number of assumptions and estimates that could result in overstated earnings and a lower P/E. Some analysts conduct "revenue analysis" to evaluate the quality of an earnings number. Revenues are less subject to management estimates and all earnings must begin with revenues. These analysts also compute the price-to-sales ratio (PSR = price per share + sales per share) to assess whether a company is performing well compared to similar companies. If a company has a price-to-sales ratio significantly higher than its competitors, investors may be betting on a stock that has yet to prove itself.

Instructions

a. Identify some of the estimates or assumptions that could result in overstated earnings.

b. Compute the P/E ratio and the PSR for Tootsie Roll and Hershey for 2017.

c. Use these data to compare the quality of each company's earnings.

The price-earnings ratio, P/E, of a company is the ratio of the market value of one share of the company's outstanding common stock to the earnings per share. If P/E increases by 15% and the earnings per share decrease by 10%, determine the percentage change in the market value per share of the common stock.

A higher P/E or M/B ratio typically indicates that:

a. A firm asset management is not efficient.
b. A firm is expected to grow slower in the future.
c. A firm has a higher level of risk.
d. A firm is expected to grow fast in the future.

Perlman Land Development, Inc. purchased land for $70,000 and spent$30,000 developing it. It then sold the land for $160,000. Sheehan Manufacturing purchased land for a future plant site for$100,000. Due to a change in plans, Sheehan later sold the land for $160,000. Should these two companies report the land sales, both at gains of$60,000, in a similar manner?

Wade Corp. has 150,000 shares of common stock outstanding. In 2012, the company reports income from continuing operations before income tax of $1,210,000. Additional transactions not considered in the$1,210,000 are as follows.

1. In 2012, Wade Corp. sold equipment for $40,000. The machine had originally cost$80,000 and had accumulated depreciation of $30,000. The gain or loss is considered ordinary.

2. The company discontinued operations of one of its subsidiaries during the current year at a loss of$190,000 before taxes. Assume that this transaction meets the criteria for discontinued operations. The loss from operations of the discontinued subsidiary was $90,000 before taxes; the loss from disposal of the subsidiary was$100,000 before taxes.

3. An internal audit discovered that amortization of intangible assets was understated by $35,000 (net of tax) in a prior period. The amount was charged against retained earnings.

4. The company had a gain of$125,000 on the condemnation of much of its property. The gain is taxed at a total effective rate of 40%. Assume that the transaction meets the requirements of an extraordinary item.

Required

Analyze the above information and prepare an income statement for the year 2012, starting with income from continuing operations before income tax. Compute earnings per share as it should be shown on the face of the income statement. (Assume a total effective tax rate of 38% on all items, unless otherwise indicated.)

Wade Corp. has 150,000 shares of common stock outstanding. In 2020, the company reports income from continuing operations before income tax of $1,210,000. Additional transactions not considered in the$1,210,000 are as follows.

1. In 2020, Wade Corp. sold equipment for $40,000. The machine had originally cost$80,000 and had accumulated depreciation of $30,000. The gain or loss is considered non-recurring.

2. The company discontinued operations of one of its subsidiaries during the current year at a loss of$190,000 before taxes. Assume that this transaction meets the criteria for discontinued operations. The loss from operations of the discontinued subsidiary was $90,000 before taxes; the loss from disposal of the subsidiary was$100,000 before taxes.

3. An internal audit discovered that amortization of intangible assets was understated by $35,000 (net of tax) in a prior period. The amount was charged against retained earnings.

4. The company recorded a non-recurring gain of$125,000 on the condemnation of some of its property (included in the $1,210,000).

Instructions

Analyze the above information and prepare an income statement for the year 2020, starting with income from continuing operations before income tax. Compute earnings per share as it should be shown on the face of the income statement. (Assume a total effective tax rate of 19% on all items, unless otherwise indicated.)

What is meant by "tax allocation within a period"? What is the justification for such practice?

What major types of items are reported in the retained earnings statement?

Discuss the appropriate treatment in the income statement for the following items:

a. Loss on discontinued operations.

b. Noncontrolling interest allocation.

c. Earnings per share.

d. Gain on sale of equipment.

Discuss the appropriate treatment in the financial statements of each of the following

a. Gain on sale of investment securities.

b. A profit-sharing bonus to employees computed as a percentage of net income.

c. Additional depreciation on factory machinery because of an error in computing depreciation for the previous year.

d. Rent received from subletting a portion of the office space.

e. A patent infringement suit, brought 2 years ago against the company by another company, was settled this year by a cash payment of $725,000.

f. A reduction in the Allowance for Doubtful Accounts balance because the account appears to be considerably in excess of the probable loss from uncollectible receivables.

You run into Greg Norman at a party and begin discussing financial statements. Greg says, "I prefer the single-step income statement because the multiple-step format generally overstates income." How should you respond to Greg?

C. Reither Co. reports the following information for 2020: sales revenue $700,000, cost of goods sold$500,000, operating expenses $80,000, and an unrealized holding loss on available-for-sale debt securities for 2020 of$60,000. It declared and paid a cash dividend of $10,000 in 2020.

C. Reither Co. has January 1, 2020, balances in common stock$350,000; accumulated other comprehensive income $80,000; and retained earnings$90,000. It issued no stock during 2020.

Prepare a statement of stockholders' equity. (Ignore income taxes.)

Indicate the section of a multiple-step income statement in which each of the following is shown. (a) Loss on inventory write-down.

Identify at least two situations in which important changes in value are not reported in the income statement.