During Year 1, Hollowell Corporation and Chester Corporation reported net incomes of $260,000 and $480,000 respectively. Both companies had 200,000 shares of common stock issued and outstanding. At December 31, Year 1, the market price per share of Hollowell's stock was $39 and Chester's stock was $36. Required:a)Calculate the price-earnings ratio for: 1) Hollowell 2) Chester b)Based on the price-earnings ratios computed in part (a), which company do investors believe has more potential for future income growth? Explain your answer.
What will be an ideal response?
| a) | (1) 30 |
Earnings per share = Net income ÷ Number of shares of common stock outstanding
Hollowell: $260,000 ÷ 200,000 = $1.30 per share
Chester: $480,000 ÷ 200,000 = $2.40 per share
Price-earnings ratio = Market price per share ÷ Earnings per share
Hollowell: $39 ÷ $1.30 = 30
Chester: $36 ÷ $2.40 = 15
b) Based on the price-earnings (P/E) ratio, investors believe that Hollowell has more potential for future income growth. While a lower P/E ratio might indicate a relative bargain for an investor, this measurement indicates that investors are willing to pay a relatively higher price (compared to earnings) for Hollowell's stock. While there are many reasons why the price of certain stocks is higher relative to earnings, one of the main reasons is confidence in future growth in earnings.
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